Our 2016 article on Investment Portfolio Rebalancing – The Basics covered the beneficial reasons to occasionally adjust your portfolio's holdings. Over time, some investment categories – asset classes – perform better or worse than others.

This causes your portfolio to be skewed away from its target allocation and exhibit a different risk and return profile that may no longer be aligned with your time horizon and risk tolerance, necessitating a rebalance back to your desired allocation.

Having covered a rebalancing example in our previous article, we will build on those concepts by reviewing risk and return characteristics, as well as the concept of correlation.

Different asset classes have distinct characteristics with respect to their expected return and risk (risk defined as short-term volatility will suffice for this article). Stocks (equities) tend to have higher expected returns and higher volatility than bonds (fixed income).

Within asset classes, sub-asset classes exhibit further differences. Equity returns of companies based in developing countries are generally seen as having higher return potential and higher volatility than those of companies based in developed countries outside of the U.S.

On the other end of the risk-return spectrum, high credit quality bonds (investment grade corporate bonds and Treasuries) and precious metals, like gold, tend to have lower expected long-term returns than stocks, but with less volatility.

These defensive asset classes often underperform "risk assets" (stocks) during economic expansions, while being seen as safe havens during periods of economic weakness. Knowing the returns of some investment categories are more similar than others, how do we quantify this?

You likely endured a statistics class at some point, so let's get a little more use out of it with one more term – correlation. The correlation between two or more variables specifies the degree to which they are related. For our purposes, we will use correlation to mean how investment returns of different asset classes move in tandem.

With correlation indicating the direction asset classes move together, the correlation coefficient quantifies this with a range of +1.0 (perfectly positive relationship) to 0 (no relationship) to -1.0 (perfectly negative relationship). The correlation coefficient therefore quantifies the level of diversification between asset classes.

For example, let's say that your portfolio holds five mutual funds that all focus on U.S. technology stocks. Many of your funds' holdings likely overlap and all of them are in the same sector. Because of this, your funds' correlations to each other are likely close to 1.0, which does not offer much diversification.

If we have a slump in the tech sector (think back to the early 2000s with the Dot-Com Bubble popping), then all five of your funds will likely decrease value in a similar manner.

To truly diversify your portfolio and provide rebalancing opportunities, your portfolio needs to hold funds that exhibit a neutral or negative correlation to stocks.

For example, the S&P 500 Index is used as a benchmark for how large U.S. company stocks are performing. The S&P 500 fell 9.1 percent in 2000, 11.9 percent in 2001, 22.1 percent in 2002 following the Dot-Com Bubble, and 37 percent in 2008 in the midst of the Global Financial Crisis.

Over those years, bonds, represented by the Bloomberg U.S. Barclays Aggregate Bond Index, returned positive 11.6 percent, 8.4 percent, 10.3 percent, and 5.2 percent, respectively.

Holding bonds to offset downside risk not only gives investors a shallower hole to climb out of following a stock market decline, but also positions your portfolio to take advantage of the subsequent rebound in equity markets.

After each of these years, your portfolio's holdings would have been underweighted to stocks following the selloff and overweighted to bonds as they held their value. This indicate a possible rebalancing opportunity to sell shares in your bond funds and use the proceeds to buy shares in your equity mutual funds at favorable valuations (think of stocks as "being on sale" after these periods of economic weakness).

Apart from a mildly down 2018 in the stock market (due to a sharp fourth quarter selloff), we have experienced a largely uninterrupted economic expansion since the market bottomed in March of 2009.

While we are unsure when the next recession will be, we would suggest reviewing your portfolio's holdings to ensure you have adequate diversification and understand how you may be able to rebalance when we have our next economic downturn.