August 30, 2009

Reviewing Your Diversification

Reviewing your account and its holdings is important to insure that you continue to be well diversified. The market has been strong overall in 2009, and especially since March 10 (market low) with the S&P 500 rising essentially 50%. If you are always waiting for the market to improve before making your investments, you run the risks of missing the big advances but being around for the pullbacks.

As I have discussed in previous posts, while the entire market may be moving forward, some parts parts may be lagging or growing faster than others. Since it is impossible to know which will be moving where, you place certain percentages (based on your age, circumstances, and risk tolerances) in various areas to spread your risk.

Some people believe that you simply look at last year's returns and pick the winners... bad move. If you remember, in January I wrote a post titled 2009 Investment Options for Your 403(b). In that post I said, "..., do not look at last year's return to just make your choices. Last year was a great year for government bonds, but this year could end up being a bad one for government bonds because they already are so highly priced which is only compounded by a very low yield. If you just feel like you have to buy them, do very little or just hold cash instead." Well, interestingly enough... I have been right. Through Friday, August 28, the US government bonds have a -2.8% return and the US government long term bonds have a -7.7% return. Cash would have been better.

Thinking about the same post from January, I also said, "After the credit markets were essentially beaten down in 2008, bonds of very high quality companies (usually called investment grade bonds) were sold down quite heavily and are still selling at a discount. If we are to believe that the U.S. economy will recover, and it will, then these bonds could enjoy some price recovery back to par along with the yield." I went on to add that if you really wanted to buy bonds in your account, please look at investment grade corporate bonds - I also gave one example of a fund available in AIG VALIC accounts. The return on the Vanguard Investment Grade Bond Fund I mentioned through Friday was +13.7%. Additionally, I discussed investing a TIPS (inflation protected bonds) as another fixed income investment, and it's return was +6.9% YTD.

What does the above mean? Really, I just want to point out that following last year's winners or even just being "safe" could in the end limit or even hurt your performance. Also, having some knowledge in the area is important. A math teacher does not teach history and vice versa. Knowledge matters.

We will all make good and bad decisions (including those knowledgeable), and the benefit of diversification is that a bad decision in one area could be countered by a good decision in another area.

Another important aspect is "rebalancing" your accounts. This means essentially getting your diversification back in line with your original allocations. Most sites allow their participants to "rebalance" their portfolio, and doing so once a year is a great idea. Don't pile everything into one category because it has done well. Instead, continue your allocations and your account (and possibly mind) will thank you.

Looking at the index returns for 2009 (this is a link to Morningstar's Index Returns site), Mid Cap and Small Cap have outpaced Large Cap. Growth has been better than value in large caps. Corporate bonds have beaten government bonds. International markets (especially emerging markets) have outpaced domestic markets (this is partly due to a weak dollar). No one could have predicted all of the above, so being invested across all of these areas should have helped your account.

Remember, broad diversification is important, and understanding that you may need help can be just as important. Don't be afraid to ask questions... I think I heard one or two teachers say that in class.

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