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Preserving Portfolio Diversification

By MarketWatch
Published | Updated

NEW YORK – The juicy returns of a hot commodity -- take gold, for instance, which hit a 25-year high of $560 an ounce recently -- can come at the expense of losing diversification in your investments.

As the value of your investments changes over time, your portfolio can become concentrated in the best-performing asset or asset class. This reduces diversification and can make you vulnerable to fluctuations in a single investment.

To preserve diversification, you may want to make adjustments that maintain the percentage of your portfolio that is allocated to each asset or asset class. These adjustments can help buffer your investments against wild market swings.

Example: If you own gold, the value of your investment has soared as the price has risen 32% over the last year. Your investment in gold has taken on more weight in your portfolio than slower-appreciating assets.

Rebalancing your portfolio means either decreasing your investment in gold, or increasing your investment in slower growers. This would limit your exposure to a sharp fall in gold prices.

Maintaining the allocation of your investments will keep you diversified. Over the long term, it should also lower the cost of your investing by preventing you from buying securities that are already priced high and offer less potential for continued appreciation.

While there is no set rule for rebalancing a portfolio, David Reilly, director of portfolio strategy at Rydex Investments in Rockville, Md., recommends adjusting your investments whenever they rise or fall by five percentage points or more. For example, if 20% of your portfolio was initially invested in international stocks, you would need to rebalance if their value increased to 25% or fell to 15%.

Reilly says that this approach may be counter-intuitive to investors who tend to buy more of whatever investment is performing best. For those who are wary, Reilly recommends investing in funds that take this rebalancing approach.

"Without some element of rebalancing, investors are not really getting the benefits of diversification," he said. "Their portfolios are left with more risk than they realize."