Understanding diversification, correlation and rebalancing

Claymore Investments, Inc. 15 May, 2010 | 4:27AM

When advisors and industry participants refer to diversification, they are generally referring to the practice of investing across several asset classes. In order to maximize the benefits of diversification, investors must create a mix of asset classes which have different characteristics and which behave differently through different times of a market cycle.

Asset classes that behave differently during different market cycles and environments are said to have a low correlation and can help maximize diversification in a portfolio. Adding asset classes or securities that have strong fundamentals, but have low correlation to other components of the portfolio will mean different parts of the portfolio may be generating different levels of return and can help provide a higher risk-adjusted return through various market cycles.

For example, when stocks correct and go down, investors may flee to the safety of bonds, which offer a higher degree of protection and capital preservation. Having both asset classes in a single portfolio may reduce the volatility of that portfolio. The goal is to create a portfolio where the sum of the parts is greater than the individual parts themselves.

Future decisions can be made to rebalance the portfolio periodically, such as monthly, quarterly or annually, back to an initial or set weighting. More seasoned and active investors could try to capture shorter-term market opportunities by increasing the frequency of the rebalancing, over- or under-weighting specific categories or adding new categories as opportunities arise.

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Claymore Investments, Inc.

Claymore Investments, Inc.