Rebalancing and Diversification work together to help you reduce risk without compromising on your goals. Both ensure that your portfolio’s risk level remains in check.
Diversification doesn't mean you put equal amounts in every bucket.
When inflation was stubbornly high in the 1970s, Commodities were about the only good investment. Having said that, those who did buy equities were rewarded handsomely in the ensuing decades—provided they hung on and never gave up.
Commodities as an asset class did well in 2021 and 2022, but was at the bottom in 2019 and 2020. This shows why investments of that nature are hard to hold on to and should be a small but consistent position in your portfolio, somewhere like 5% or less. They offer diversification, but also extreme volatility.
Ditto with sector funds. Should you decide to invest in one because of your conviction, it must form a small portion of your portfolio, The bulk of your portfolio should be between equity and debt, depending on numerous personal factors.
Look at the annual returns of various asset classes over the years, and it will give you a sense of how hard it is to predict each year's winners. Diversification is clearly the reasonable response.
Rebalancing puts the cyclical force of the markets to work for your benefit.
The investing ecosystem is a self-correcting environment. If one investment type has a long run of strong returns and another area has had poor returns, they may well flip places over the next few years. The market overdoes rallies and selloffs in the short run, but it corrects for that eventually.
Rebalancing makes use of this market disposition. Rebalancing helps by buying low and selling high without attempting any market forecasts. And keeps your portfolio from getting dangerously out of whack.
The above is an extract from Russel Kinnel's more detailed Diversification in a bear market