Are you currently holding a mutual fund that is not performing well compared to your other assets? Before dumping it, consider that it might be an indicator that your investment portfolio is well-diversified.

I’ve written often on this topic, but it’s still worth reviewing how diversification works. In non-mathematical terms, it’s the inclusion of multiple assets in a portfolio that do not all perform the same way at any given time.  What’s the benefit?  It reduces the volatility (i.e. risk) that an investment portfolio would experience over time if invested in just a single asset.  That’s pretty intuitive.  What’s less intuitive (and even more powerful) is that diversification has the potential to increase the overall return of the portfolio as well.

For example, in the last quarter of 2015, the average return across all healthcare stock mutual funds exceeded 8% according to Morningstar. That’s 8% in just three months!  Sounds like a pretty good asset class to be holding in your portfolio.  In the first quarter of 2016, however, that group of funds dropped by over 13% on average.  That’s what I’d call volatile!  If you’d invested your entire portfolio in an average-performing healthcare stock fund at the beginning of October, by the end of March you’d have exited the roller coaster 6% poorer (and probably with less hair as well).

What if instead you’d invested in a world bond fund? That category performed poorly in Q4 2015, losing 0.6% on average.  But in the first quarter of this year the average fund was up 4.3%.  Splitting your portfolio equally between these two asset classes would not only have reduced the volatility over the period but would also have increased your overall return as compared to investing just in healthcare stocks.  The reason diversification worked in this case was because those two asset classes did not behave the same way or, in mathematical terms, were not highly correlated during that period.

The point here is that in any given quarter, a well-diversified portfolio should contain some well-performing assets as well as some underperforming assets. You should avoid the temptation to sell the latter simply due to short-term performance, especially if you invested in that asset class precisely for diversification purposes.  In fact, if all your investments had good returns last quarter, that should be cause for concern.  After all, if your assets are all up now, what might happen if the markets or the economy were to reverse?  The last thing you want is for everything you own to collapse at the same time.  (That’s what happened to a large extent in 2008.)

This is not to suggest that poorly-performing funds should always be kept. If your fund is returning less than other funds within the same asset class, or is experiencing higher volatility, that might be an indication that the management team is not following a strategy or operating the fund in a manner consistent with your goals for investing in that asset class.  But before pulling the trigger and selling it, find out why.  And if you do decide to sell it, be sure to replace it with another fund from the same asset class.

It may sound counter-intuitive, but at any given time you should expect some of your investments to be performing poorly. That’s the sign of a well-diversified portfolio.  It’s only when everything is going too well that you should be prepared to take action.