Diversifying your investment holdings has come under criticism over the past several years. The reason is simple: large U.S. companies have dominated the global growth scene and delivered the most in terms of gains in many investment portfolios. If you study markets, it seems that certain sectors may have hot streaks whereby any given sector may lead the markets for a year or two – but rarely does any one sector dominate as the Standard and Poors 500 index has in the past decade.
Another interesting comment for those who study markets is that sectors do go from first to last, and vice versa from year to year. It can be seen that the sectors on the top of the pile or the bottom of the pile for a prolonged period sometimes revert to the other end of the performance spectrum. The challenge is figuring when they might go from last to first and making the moves in your portfolio to accommodate your intuition or best guess.
For that reason, it may be wise to consider building a portfolio that is both diverse and built around those drivers of returns you think are most important. For example, just because an investment was a top performer last year generally is not a reason to think it will be a top performer in the next year. Perhaps a more significant driver of returns are profits.
After all, the intrinsic value of a company is measured as a multiple of its profits and the valuation of assets on its balance sheet. Of course, companies trade at, above and below their calculated intrinsic value because of speculation, supply and demand or other reasons to believe that a company will be valuable someday. Remember, tens of millions of shares in companies trade each and every day. For the most part, sellers feel that it was a good time for them to sell and buyers feel like they invested in something that has a chance to generate income or appreciate. Someone will be right.
The theory behind diversification may mitigate some risk, but it is not guaranteed to minimize your losses. The benefits of the theory stem from the reality that no one knows when any particular area of the market is going to rise or fall. As a result, the theory suggests that a broad range of holdings in multiple sectors allows you the opportunity to benefit from a rising sector. Under this theory, however, you are also likely to own sectors that decline.
This is where rebalancing your portfolio can help. When you rebalance, you are trying to bring your allocation back in line with the amount of risk that you would like to assume. That frequently leads to a trimming of your winners and adding more to your losers. By definition, this little move helps with what many investors desire, to buy low and sell high.