What Are Diversification and Rebalancing?
Diversification and rebalancing are two key investment strategies that can help you build a resilient portfolio and reach your financial goals. When used together, they reduce risk, improve long-term stability, and ensure your investments stay aligned with your personal financial plan.
Why Diversification Matters
Diversification is the practice of spreading your money across different investments and asset classes to reduce the risk of loss. The idea is simple: do not put all your eggs in one basket. If one investment performs poorly, others can help cushion the impact. You can diversify between asset classes, such as stocks (equities), bonds (fixed income), and cash equivalents, and within asset classes, such as investing in a variety of companies and industries. A well-diversified portfolio helps reduce the risk associated with any single investment or sector underperforming.
Tailoring Your Portfolio: Time Horizon and Risk Tolerance
Your portfolio’s structure should reflect your time horizon and risk tolerance. Time horizon refers to how long you plan to invest before needing the money, such as saving for retirement or buying a home in 10 years. Risk tolerance is your comfort level with market ups and downs.
- If you have a conservative risk tolerance, you might prefer a portfolio with more bonds and cash equivalents and fewer stocks.
- If you have an aggressive risk tolerance, you may be comfortable with more stocks in pursuit of higher returns (even if it means facing more volatility.)
Most people fall somewhere in between, and your personal mix will depend on your comfort with risk and your investment timeline.
The Role of Rebalancing
As markets fluctuate, some investments in your portfolio will grow faster than others. This can cause your asset allocation to drift away from your original plan. Rebalancing is the process of adjusting your portfolio back to its intended allocation. For example, if your goal was a moderate allocation of 50% stocks, 45% bonds, and 5% cash, but your stocks grew and now make up 65% of your portfolio, it is time to rebalance. There are two common rebalancing strategies:
- Time-based: Rebalancing on a set schedule, such as quarterly or annually.
- Threshold-based: Rebalancing when an asset class exceeds a certain percentage of its target.
Whichever method you use, staying consistent is key. Failing to rebalance can throw off your investment strategy and put your financial goals at risk.
Final Considerations
Diversification spreads risk. Rebalancing keeps your investments aligned. Together, these strategies create a smart, disciplined approach to investing, helping you grow your wealth while staying on track for the future.
It may also be beneficial to consult with a financial advisor to ensure your investment choices align with your personal financial goals.