by Archie M. Richards, Jr., CFP^®
October 31, 2005

Double-diversity and rebalancing are keys to successful investing. They lower risk and increase returns.

Take risk first. Assume you buy a Certificate of Deposit that pays 3 percent. The prices of CDs are always $1.00 a share - no volatility there. The value of the account changes only because of the interest credits.

Alternatively, let's say you put your money into a portfolio of large U.S. stocks. Based on the record of the last 80 years, you'd expect a return of 12 percent a year. But the price volatility will be a roller coaster ride from minus 20 percent at one time to plus 20 percent in another - a range of 40 percent.

The annual return from the stocks (12 percent) is 9 points higher than that of the CD (3 percent). But the price volatility of the stocks (40 percent) is 40 points higher than that of the CD (zero). The volatility rises faster than the return.

Investors think the volatility of stocks is evidence of an irrational marketplace. They're wrong. Stocks pay well. But in comparison with the volatility, they don't.

Cutting the volatility is vital to successful investing. If you fail in this, your emotions may become ensnared by down markets, making you sell stocks when things look bad and prices are low.

How do you cut volatility?

• First, don't buy individual stocks, unless you acquire a ton of them from various industries and countries. One stock is likely to be very volatile indeed. But the return is unlikely to be higher than that of the market.

  Instead, diversify into index funds or exchange-traded funds. Each one buys all of the stocks of a certain type - hundreds of them. The volatility of the fund is less than that of each component.

• Secondly, for double diversity, buy several index funds representing different investment sectors.

  Here's an illustration of how that works: If you hold 85 percent bonds and 15 percent stocks, the inclusion of stocks makes the returns higher than that of a portfolio invested solely in bonds. But the volatility is nevertheless unchanged, because the up-and-down price movements of the two sectors don't match.

  You want many index funds or ETFs whose price movements don't correlate. When one sector is falling, another may be rising. This cuts the risk. But the inclusion of stocks makes the returns highly satisfactory.

• Finally, rebalance annually. (If the funds are held outside of an IRA or pension plan, make it at least a year and a day, to avoid high-taxed short-term capital gains.)

  Let's say you put 10 percent of your portfolio into an index fund of large, U.S. growth stocks, which perform well. A year later, this segment is worth 13 percent of your entire portfolio. Sell 3 percent, to bring the holding back to 10 percent of the portfolio. Reinvest the proceeds into index funds that have not done well.

  You'll be selling portions of some index funds when they're high and buying others when they're low. Isn't that the whole idea - buying low and selling high?

Sometimes, the price trend of an investment sector may go down for several years. But an entire sector never falls to zero. An individual small-growth stock may go busted, for example, but an index fund of all small growth stocks would not.

All poorly-performing sectors eventually turn around. Those that have performed badly start doing well, and those that have performed well start doing badly. We'd all like to invest only in winning sectors if we could. But we don't know in advance which ones they'll be. Instead, buy them all and rebalance, selling when they're high and buying when they're low.

You don't need to rebalance more often than annually. And if no segment has moved as much as 30 percent from your intended percentages, leave the portfolio alone.

Your friends may boast about a hot stock they've just bought. Don't tell them you just reduced your holding of that kind of investment and bought more of the kind your friends don't care about.

Your friends don't need to know that double diversity and rebalancing will eventually make you a lot wealthier than they are.