At Flat Fee Portfolios we believe that broad diversification not only matters, but is a prerequisite to any portfolio’s long-term success. Dividing assets across various asset classes can help manage the overall volatility of a portfolio, as well as potentially increase expected returns. Different asset classes have a variety of risk and return characteristics, as well as imperfect correlations with each another. The investor benefits in the end because they do not all move in the same direction at once
The effect is illustrated in the example below. As assets such as Small Cap, Value, International, and Emerging Markets stocks were added to increase the diversification, the overall risk in the portfolio stayed roughly the same, while the return experienced over the period increased from 9.47% for a portfolio invested solely in the S&P 500 to 11.65% for a portfolio that included more diverse equities.
Favorable environments for some asset classes may be less favorable for others. It is impossible to predict with any certainty which asset classes will be the best, or worst, performers in the future. Broad diversification helps investors avoid this folly. Investors who broadly diversify will never have all their eggs in the winning basket, but they’ll never have all of them in the losing basket either.
Source: "Guide to the Markets, Q4 2011," J.P. Morgan Asset Management, www.jpmorganfunds.com
Regularly rebalancing a diversified portfolio back to the target allocation helps reduce risk by systematically selling assets that have appreciated, and may be overvalued, as well as purchasing assets that have underperformed, and may well be undervalued.