There are many items, which consumers must understand in order to become reasonable investors and to have an understanding of why the markets work the way they do. In many instances, these items are somewhat counter intuitive, meaning that you need to go “against the grain” in order to make your long term strategy pay off.
Two of these items are diversification and rebalancing. Learn and memorize these terms as they are crucial for any investor to know and understand.
“Putting all of your eggs in one basket” would be the opposite of diversifying.
All too often, people want to buy what’s “hot,” they don’t buy what’s appropriate. The best explanation I have ever heard about diversification concerns a baseball analogy. Let’s say during a baseball game five hits in succession go to right field. Does that mean the manager should call time out, remove all of his position players from their normal positions on the field and place them in right field? Probably not, as there is no guarantee the NEXT ball in play will go to the same area. Just because one investment lead the market today does not mean it will lead it years into the future. Should you have some money in these areas…absolutely, but make sure there is proper diversification over all segments of the market. This means you will not have to worry when sectors go in and out of favor.
Rebalancing a portfolio
is a term that is used in conjunction with diversifying because it means going back to your original portfolio objective to continue to maintain balance and take profits.
Let me explain in a bit greater detail. Assume your base portfolio as constructed was one third each in bonds, domestic stocks, and international stocks. As we all know, markets do not move in tandem and percentages in each category can become “skewed” over time. Let’s assume, in this example, that after one year, the portfolio was 40% domestic stocks, 35% international stocks, and 25% in bonds. Rebalancing would mean taking 7% from the domestic category, 2% from the international category with proceeds being used to buy bonds. This is one of the few ways that consumers can take regular profits and continue to buy low. If bonds are out of favor today, they may not be a year from now, and taking the opportunity to buy them when they are out of favor, as difficult mentally as that may be, may put you in a better position in the long run. Rebalancing is something you should consider annually, and should be done without any emotion. It is the reason why having a baseline understanding of asset categories and percentages is essential in understanding and following the markets.
Neither diversification nor rebalancing can guarantee a profit or protect against a loss.