Ask Paul: What about mid-caps?
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August 15, 2005
Why don’t you include mid-cap funds in your Suggested Portfolios? Is it because large-cap and small-cap funds already contain enough mid-cap exposure?

Paul's answer:


That is one reason, but it’s not the main reason. We believe in what we call smart diversification. Smart diversification lets you mix two assets together and achieve a higher return, with less risk, than the average of those two assets.

Choosing the right assets for this is critical. For smart diversification to work, it has to involve more than just owning different assets. They have to be assets that behave differently from one another. Mid-caps usually don’t help much on this score. Typically, their behavior is not radically different from that of large-cap stocks nor from that of small-cap stocks. Mid-caps are typically right in the middle.

One of the best things investors can do is annually rebalance their portfolios to bring their actual asset allocations in line with their target allocations. This keeps risk under control and has the beneficial effect of forcing investors to take some gains from asset classes that have done well (This is called selling high) and to reinvest those gains in asset classes that have struggled (This is called buying low).

Here’s the bottom line: To take advantage of smart diversification and effective rebalancing, we prefer to invest at the ends of the size spectrum instead of in the middle. 
 
 
 

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