Double Your Life-Time Investments with Diversification and Rebalancing

Are you ready to build your portfolio but don’t know where to begin? Building a portfolio might seem like a daunting task and challenging for many people, but in reality, it’s not very hard, and even the best investors can tell you it’s much simpler than you think. Learning and following only a few simple rules over a long period of time will keep you out of danger, while also getting the maximum return on your portfolio. This can all be done with minimal research and only a few hours a year for rebalancing. Let’s take a look.

2 Key Principles to Investing

If you follow the 2 key principles to investing, you will be able to outperform most investors, and the market itself.

Diversification

The first being diversification, which is critical, yet many people get this wrong. Diversification doesn’t simply mean owning a variety of assets; it means owning a variety of uncorrelated assets. This means owning various assets that will not be affected by the same economic conditions.

Rebalancing

The second principle is rebalancing. This means that you have a set percentage that you want to hold of each asset, and from time to time, you will sell something that has a higher percentage than your target and buy something that has a lower percentage than your set goal. This essentially equates to selling outperforming assets to buy underperforming assets. The net result can have a huge impact on your portfolio in the long run. Let’s dive in to discuss.

Keep It Simple, Stupid (KISS)

In order to accomplish this, you do NOT need to know Modern Portfolio Theory or Efficient Market Hypothesis, or Odd Lot Theory, but rather KISS – Keep It Simple, Stupid!

Hypothetical Analysis of Company AAA

We’ll use a fake company – AAA, Inc. as a hypothetical – Ticker: $AAA

The great thing about $AAA is that the value goes up 30% in 4 out of 5 years – 80% of the time. BUT the other year, it goes down 50% (so, 1 out of 5 years). Remember this is a hypothetical. There is no way to know which 4 of the 5 years it will go up.

Let’s assume we just buy $AAA and hold it for 25 years. What type of return will we get over 25 years if we simply buy it and do nothing? During that 25-year period, we will have:

• 20 years – 30% up
• 5 years – 50% down

This will result in 7.39% annually – or every $1 > $5.94 over 25 years.

Let’s add a second stock to the equation: ZZZ, Inc. Ticker $ZZZ

$ZZZ has exactly the same outcome statistically as $AAA. It goes up 30% in 4 out of 5 years and down 50% 1 of every 5 years. However, they don’t move in unison. Some years they may both go up, other years they may both go down, and sometimes they may move in opposite directions – one up and the other down.

The more frequently they move up and down together, the more they are correlated. This is what we don’t want, because we want assets that are uncorrelated to take advantage of the diversification.

The entire concept of diversification really means attempting to buy assets that are uncorrelated.

Let’s say that X% of the time, both of our stocks go up at the same time. Thus, the greater X is, the greater the association. Now, basic probability calculations tell us:

• Our stocks will decline together (X – 60) %
• When moving in opposite directions it will be (160 – 2X) %

Additionally, none of the probabilities in our 2×2 diagram above can be negative.

Therefore, neither (80 – X)% nor (X – 60)% may have a negative value.

So, X must be somewhere between 60% and 80%.

Our stocks are at their maximum level of negative correlation at X = 60%.

Also, their association becomes considerably positive as we increase X from 60% to 80%.

At X = 64%, the transition from negative to positive occurs. At that point, there’s no correction between the two stocks.

The main idea behind diversification is that everything shouldn’t collapse at the same time

– in other words – RISK control.

This is the reason we want negative correlations. Positive correlation doesn’t give us any protection because that would mean the assets move up and down in price together.

Applying Intelligent Rebalancing

But to truly take advantage of negative correlations, we need a second essential concept: intelligent rebalancing.

To determine why, let’s run some calculations.

Let’s say X is 60%. In other words, the correlation between $AAA and $ZZZ is as low as it can be (uncorrelated). And will have a 50/50 split of $AAA and $ZZZ. Now, we’ll hold this portfolio for 25 years and NEVER rebalance it. What will our return be?

If we don’t rebalance, each stock will continue to perform on it’s up. Each will go up 20 years and down 5 years, but in different orders. Giving us the same result, we calculated previously: 7.39% or 1 > $5.94.

So, if we diversify, but don’t rebalance, then there is no benefit to diversification. But what happens if we periodically rebalance, let’s say once a year?

For instance, if $ABC rises and $XYZ falls over the course of a year, we should sell some $ABC at year’s end and use the proceeds to purchase some $XYZ, bringing our portfolio’s 50/50 split back.

Here are all the events that could possibly occur in any given year, along with their corresponding probability, assuming the implementation of this rebalancing strategy:

So, when X = 60% (the strongest negative correlation in our calculation) – our portfolio:

• 3 out of 5 years we see in increase of 30%
• 2 out of 5 years we see a decrease of 10%

So, over 25 years we would see an annual return of ~12.22% or $1 > $17.85.

See the following chart for a deeper look into the mathematics behind rebalancing:

As a result, when X = 60% (i.e., there is a strongly negative correlation), we get:

Without re-balancing, $1 becomes about $5.94. But with it, it becomes about $17.85, which is more 3X as much during the same 25-year period!

This is a great example of using negative correlations and re-balancing your portfolio. Done correctly, on a consistent basis, with uncorrelated assets is the ideal way to manage your diversified portfolio. I think we’ve all heard the following chant: Diversify, Diversify, Diversify! Many people have heard of the concept of diversifying, but also don’t truly understand what diversification means, but the rebalancing portion is typically left out, and this is one of the most important aspects to learn about.

In my illustration of the 2-stock portfolio, we saw a return of ~7.39%, but then the same portfolio re-balance yearly yielded ~12.22%.

This is what portfolio diversification is and how it’s used properly. The largest and most successful funds in the world use this similar strategy, albeit on a much larger scale. In a simplistic way, the idea is that we sell our overvalued stocks to buy our cheaper stocks.

One of my favorite investors of all time, Ray Dalio, says, “The Holy Grail of Investing is to buy 15-20 uncorrelated return streams. You can dramatically reduce your risks without reducing your expected returns.” For most of us 15-20 may not be ideal and possibly over-complex. There are many low-cost funds that hold a basket of specific assets that can dramatically reduce the risk, and a great way is to diversify in several uncorrelated basket funds.

Here are some examples of low-cost ETF’s

Conclusion

Building and managing your portfolio is much easier to do than most people think. Do your research and try not to overthink it. Selecting a diversified portfolio of uncorrelated assets and then rebalancing the portfolio twice a year is all it takes.

The examples might appear to be overly complex math, but in reality, you don’t need to use these calculations to find out correlations of assets, but rather understand the concept.

The important thing is to understand the basics of correlations.

A simple 4 asset example could be the (1) S&P 500, (2) Gold, (3) total bond market, and (4) emerging markets – it doesn’t need to be overly complicated. Once you have your portfolio, set reminders on your calendar to re-balance. Do this every year, consistently. It might seem very boring, but it’s a tried-and-true method used by virtually every successful fund manager. Follow these two simple concepts with your life-long investment strategy and you will be rewarded for doing so!

If you’re curious to learn more about diversification check out this article.

Frequently Asked Questions – FAQ