Last Updated Feb 26, 2010 10:28 AM EST
The following example, created by my Buckingham Asset Management colleague Vladimir Masek, shows how even an investment that loses money persistently can add value to a portfolio. It also demonstrates why rebalancing is an integral part of the strategy of diversification of risk. (In a sense, that's a trivial observation because without rebalancing, each investment will do what it does, and at the end of the investment horizon you just have two undiversified portfolios that have been put together.)
Consider two investments with the same distribution of returns:
- Half the years, they each return +60 percent
- Half the years, they each return -40 percent
At this point, you don't even care what the correlation is between the two assets because you're considering the assets in isolation. However, you need to know the correlation if you rebalance.
Now consider the following case of a portfolio with an allocation of 50 percent to each asset, rebalanced annually. In the most extreme case (with the assets having a correlation of -1), you don't know beforehand which asset will go up 60 percent and which will lose 40 percent in any given year. However, you don't care. You always rebalance back to 50/50 each year. So, what's the result of combining these two money-losing assets in a portfolio that's rebalanced annually? If you rebalance, your total $200 investment is now earning exactly 10 percent every year. It's like a Treasury bill investment with a very high interest rate.
Of course, this is an extreme example. However, it demonstrates the importance of considering how the addition of an asset impacts the overall portfolio. It also demonstrates that assets with negative correlation can have low expected returns and high volatility and still add value to a portfolio.