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Diversification and Rebalancing: Why They Are Critical When Markets Are Volatile and Asset Values Are High

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We’ve seen a tremendous amount of volatility in the investing markets so far this year — and we’re not even through the first quarter yet.

For example, the Dow Jones Industrial Average started off the new year with a bang, breaking through the 25,000 and 26,000 point barriers in January alone before tumbling precipitously in early February and entering official “correction” territory.

Riding the Roller Coaster

Roller-coaster rides like this are what keep some people on the sidelines when it comes to investing in stocks. But it’s important to remember that volatility is a part of stock market investing.

A good tool for measuring market volatility is the VIX volatility index, which spiked to 37 in early February after the Dow closed down nearly 1,200 points in one day. For comparison’s sake, the VIX was below 9 just a month earlier on January 4. By mid-February, the VIX had fallen to 19 as the market began to rebound.

Also, despite the correction in stock prices that occurred in early February, equities remain relatively expensive from a valuation perspective. The cycle-adjusted price/earnings ratio, or CAPE, is a tool used to gauge stock market valuation. In mid-February, the CAPE stood at 33.6, the second highest level ever — even higher than before the stock market crash of 1929.

During times of high market volatility and high asset valuations like we’re experiencing now, it’s important to remember two bedrock principles of investing: diversification and rebalancing.

Spread Out Your Investments

Diversification is the spreading out of investments within a portfolio among securities across the three main asset classes of equities (or stocks), fixed-income (or bonds) and cash equivalents. Having a well-diversified portfolio can reduce the impact of volatility by smoothing out market returns. For example, sharp declines in stocks can be offset by relative stability in bonds and cash equivalents.

You can also diversify your holdings within a particular asset class. With equities, for example, you can own international and domestic stocks, mutual funds and exchange traded funds (ETFs) as well as the securities of small-cap, mid-cap and large-cap companies. You can further diversify your stock portfolio by investing in companies across a wide range of different industries such as healthcare, technology and telecommunications.

Many investors fail to take advantage of the potential benefits of international diversification, in particular. The performance of stock markets varies greatly all around the globe, but a lot of U.S. investors have a “home country” bias and only invest in domestic stocks. However, less than half of the world’s economic activity occurs in the U.S. — so not diversifying internationally could mean missing out on strong economic growth and equity returns in other nations.

Rebalance When Necessary

Rebalancing, meanwhile, is the process of examining your portfolio periodically to make sure that your desired allocation of assets across the three categories is still in balance. This is especially important when one particular asset class has risen or fallen tremendously in value.

For example, broad U.S. stock markets have risen significantly over the past year. As a result, gains in your equity holdings may have lifted the proportion of domestic stocks in your portfolio (when compared to bonds and cash equivalents) higher than what it should be. If so, you may want to sell some equity positions and use this money to buy fixed-income and/or cash equivalents to help bring your portfolio back into balance.

Control What You Can

There’s nothing you can do as an investor to prevent stock market volatility or affect equity valuations. But by utilizing the strategies of diversification and rebalancing, you can help lessen their impact on your portfolio and keep your long-term investing strategies on track.

Please contact us if you have more questions about the roles of diversification and rebalancing in meeting your investing goals.

The commentary is limited to the dissemination of general information pertaining to Frontier Wealth Management, LLC’s (“Frontier”) investment advisory services. This information should not be used or construed as an offer to sell, a solicitation of an offer to buy or a recommendation for any security, market sector or investment strategy. There is no guarantee that the information supplied is accurate or complete. Frontier is not responsible for any errors or omissions, and provides no warranties with regards to the results obtained from the use of the information. Nothing in this document is intended to provide any legal, accounting or tax advice and Frontier does not provide such advice. This information is subject to change without notice and should not be construed as a recommendation or investment advice. You should consult an attorney, accountant or tax professional regarding your specific legal or tax situation.