Diversification, Rebalancing, and the Pain to Gain Ratio - Bringing it all Together

In previous posts, I've stressed the importance of diversification and finding an asset allocation that reflects an investor's risk tolerance. The following chart illustrates the rates of return of the major assets categories, both during the market decline that began in October of 2007 and during the market rebound that began on March 9th.


Several points here. First, although we have all enjoyed the recent rally in the stock market, don't trick yourself into believing the market will quickly recoup your losses. Recall the pain-to-gain ratio (previous post) which illustrated how a 50% loss would require a 100% gain in order to break even. As enjoyable as the past three months have been, most asset categories aren't even a third of the way to recovering the losses suffered during the 15 month downturn.

Second, an appropriate asset allocation is crucial. An investor with a significant portion of a portfolio invested in bonds clearly came out ahead of the market during the down time, and now has much less to go in order to break even. For instance, a portfolio of 50% stocks and 50% bonds was likely only down 20% during the market pullback, and would only need a positive return of 25% to break even. This investor is close to getting back to even already.

Lastly, as many financial professionals predicted, many of the asset categories that were hit the hardest during the recession have come back the strongest. Mid cap, small cap, and international stocks, all big losers during the market decline, are the biggest winners since the turnaround. Consequently, investors who were committed to their investment approach utilizing a diversification and rebalancing strategy have been rewarded. Individuals who didn't stick to their strategy sold at or near the bottom, and have missed the bounce.