By John Lunt, President of Lunt Capital Management, Inc.

“The key to keeping your balance is knowing when you’ve lost it.”

As we approach the end of 2016, investors will ask the question: “Do I have the right balance in my portfolio?”

A follow up question for each investor could be “What are we balancing between?”

The answer requires identifying the appropriate trade-off (balance) between risk and return, between market risk and strategy risk, between correlation and magnitude, between U.S. and international, and between offense and defense just to name a few. There are times that the market waves seem especially fierce, and it is easy to lose portfolio balance. At other times, the waves seem easy to ride. These lulls can be especially dangerous, as it creates a tendency to relax and ignore proper technique. This makes an investor susceptible to even minor, unexpected volatility.

In the recent past, it was difficult to create balance in portfolios because of the inability to efficiently access a wide array of asset classes and strategies. ETFs have been a game changer—portfolio balance is now within reach. ETFs facilitate the creation of portfolios with the right balance, as index-based ETFs are transparent in holdings, costs, and methodology. ETFs provide the ability to target both broad and specialty allocations. The fact that they are traded on exchanges allows for their use in risk-managed and return-seeking strategies.

What does balance mean? Each investor is unique, and balancing tradeoffs will vary based on objective, risk capacity, financial condition, and time horizon. It is valuable to highlight what portfolio balance does not mean. It does not mean always using a pre-packaged investment product with “balanced” in its label. This may or may not bring appropriate balance to an investor. A balanced portfolio does not mean a 50%-50% split between the two elements that the investor is trying to balance between. In other words, portfolio balance does not connote equal. Imagine standing on a surfboard. As the waves and tide move below, an experienced surfer will shift his or her weight in order to keep balanced and remain standing on the surfboard. Careful, thoughtful investors will shift the balance across key elements within a portfolio in order to navigate specific market waves, currents, and tides.

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Any return-seeking portfolio requires accepting elements of risk. Market risk is broadly defined as the risk associated by simply owning a specific asset class. This might be referred to as “market beta,” or the return associated with the market. Strategy risk is broadly defined as the risk associated with a decision that would move the portfolio away from simply owning a particular asset class weighted according to its market capitalization. These strategies would include passive, alternative weighting approaches (smart beta) in addition to active, tactical management.

It is important to balance “market risk” and “strategy risk” within portfolios.  Some market forecasters have expressed concern about projected market returns. This implies less confidence in the reward associated with the level of risk embedded in a particular asset class. This may suggest a need for additional strategy risk within that asset class.  As with market risk, strategy risk comes in all shapes and sizes. Some strategy risk has a high degree of embedded “beta” (this includes some “smart beta” strategies), while some strategy risk may have times with low or no “beta” (strategies that can significantly reduce or leave asset classes).  The ability to withstand negative variation from a market benchmark should guide the amount of strategy risk introduced into a portfolio. This recognizes that transferring risk from market risk to strategy risk does not eliminate risk. Instead, the risk simply changes form.

A foundational principle of diversification is combining asset classes and sectors that do not always move in tandem with each other. In other words, building a portfolio with assets and strategies that have lower correlations to each other. It is noteworthy that correlations are not static, and they will look different across time periods. There is concern among investors about increasing correlations across some asset classes. However, correlation does not capture magnitude. Two asset classes may be highly correlated, but Asset Class A is up 2% and Asset Class B is up 20%. Including a combination of both in a portfolio may make sense, despite the high correlation.

RELATED: ETF Investors: The Real Action is Beneath the Surface

It is essential for investors to find the right balance between “offense” and “defense” within their portfolios.  Combinations of asset classes and strategies can be formed to create growth-oriented allocations, principal-protection allocations, and everything in between. While the “right balance” is unique for each investor, the ETF tools used to achieve this balance are widely available. Creating balance is within reach if the ETF tools are used correctly.

As an example, I have two teenage daughters that play soccer. One plays forward, while the other plays keeper.  Their respective roles are both important, but are very different. It would lead to disappointment if the team expected my goal keeper daughter to score goals. Likewise, an expectation that my daughter playing forward could regularly stop shots on the goal would be unrealistic. Investors expecting their defensive allocations to score points will be disappointed. It may result in replacing truly defensive allocations (that will not score many points) with defensive allocations that are really disguised as offense. This masquerade can also take place in the growth or offense-oriented portion of the portfolio.

If you have lost portfolio balance, it is time to get it back! What may have been the right balance a year or two ago may have changed. Market currents and tides are ever-changing, which requires a continual search for the right investment balance. Fortunately, we have a seemingly endless array of ETF tools to help us all to strike the right balance.

John Lunt is the President of Lunt Capital Management, a participant in the ETF Strategist Channel.

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