Risk Diversification & Why It’s Important to Your Portfolio
Risk diversification in retirement is one of the most important concepts in investing and finance, yet many people immediately look for the door or turn off mentally when the topic comes up.
That’s understandable, as it can get complicated.
The fact is you don’t have to become an expert in diversification, but you should know it exists and have a basic understanding that it can be critical to growing your money.
And you should be willing to work with someone knowledgeable when it comes to utilizing risk management strategies that can help protect your valuable assets while potentially delivering higher returns over time. At Oak Harvest, this approach is part of our DNA.
Today we are going to look at:
- What it means to spread your risk through proper diversification and what can happen when you don’t
- What real diversification is
- Types of assets that can be used to diversify a portfolio
- Proper allocation of assets
- Key advantages of diversification
All Your Eggs
You’ve surely heard the term, “Don’t put all your eggs in one basket.” Pretty straightforward concept – if you were to drop the basket or even just accidentally bang it hard against something while walking, you might not be eating eggs for breakfast.
Kidding aside, the simple act of placing your eggs in different baskets pretty much ensures that any one event won’t wipe out all your eggs.
OK, enough of the “spreading your eggs around” analogy.
Let’s talk about something serious, such as your money. Yes, yes, yes, you know it’s never a good idea to keep it all in one place. You’ve got it taken care of in terms of protecting it, with a little here, a little there, some in your employer-sponsored plan, some CDs at the bank, and your secret emergency stash tucked up under the mattress…just in case.
Yes, you are diversified. Doing so has spread out your risk, ensuring your money will be just fine.
Were it all that easy…
A not-so-funny thing about diversification is the fact that so few people know much about it. Turns out that included some within the financial services industry not so long ago.
In the aftermath of the 2007 to 2009 financial meltdown, a lot of smart people were left scratching their heads wondering how their carefully crafted portfolios didn’t fare so well. They had diversified for that very type of event.
Well, without bogging down into gory detail, it turns out many found that while they thought they had adequately spread their risk through diversification they had asset holdings that were highly corelative.
In other words, on the surface the asset mixes they incorporated to protect were related in ways they failed to recognize, so they ended up overweighted in a manner they didn’t recognize, leaving them much more vulnerable than understood beforehand.
As you are aware, there was historic wealth destruction in that period. Very tough lesson for many individuals…and some advisors!
What is Diversification?
This begs the question of what is diversification and what does it mean to you? Let’s start with what diversification is in a nutshell.
When it comes to diversification, the notion is that you should spread your various investments into different types of assets so you limit your overall exposure to any one type.
Easy enough. Don’t buy just one stock. Or don’t buy multiple oil and gas stocks in an attempt to spread your money, as they can all get gutted if the barrel price of the commodity heads decidedly south, as has been known to happen.
Yes, it does get more complicated and involved than that, but at its core diversification is about mitigating risk and trying to maximize returns responsibly by investing in different asset types.
It’s important to remember that asset classes move in different cycles at different times for myriad reasons and factors. So you need to spread your portfolio among different asset classes accordingly. Some of the types of investments to think about are:
Stocks – Domestic and International
As an investor, you are familiar with this type of asset. They can be income-producing, such as large-cap dividend stocks, or small to mid-cap equities issued by companies that are geared toward growth and who are capable of producing tremendous upside in terms of price appreciation.
Comparatively speaking though, stocks are highly volatile, especially in short-term periods. Even the big dividend-paying stalwarts can depreciate considerably during certain market periods. And if you happen to need your money at that particular time, you will certainly begin to appreciate how risky stocks and the equity markets can be.
When it comes to international stocks, they can offer exposure to other markets that may perform better and offer higher returns than the U.S. equity market at any given time. But with the increased potential for return, they can be much more volatile than U.S. investments.
They can range from treasuries issued by the U.S. or foreign governments to state and local municipalities, or corporates issued by corporations. They can be bought directly or through bond funds and ETFs. U.S. Treasuries are considered safe, but offer less yield, while higher-yielding bonds, such as foreign gov’t or corporates come with more risk.
Overall, bonds tend to be safer and less volatile than stocks, so they are generally considered an income producer and a hedge against equity market volatility. They are typically found in a properly constructed portfolio.
Mutual Funds and ETFs
You are likely familiar with these instruments that tend to invest in large baskets of assets, ranging from stocks, bonds, real estate, a combination of asset types, and more.
Investing in one can provide tremendous diversification on the one hand (ex.- S&P 500 fund), but can open you to market risk if we see a market correction, or worse. Investing in different types of funds (capital appreciation, managed to a target date, income, allocations, hedge against inflation, etc.) can address being too weighted and vulnerable to any given asset class.
CDs, money markets, etc. Less volatility, but often offer less liquidity and lower returns. Some don’t come with FDIC insurance, although CDs do. The plus can be safe when other areas go south, but the downside is the fact the returns tend to get outpaced by taxes and inflation.
Many types of assets are very mainstream now that are utilized to create balanced exposure while helping to diversify. Examples include things like commodities (direct or through funds), REITs, annuities, and more.
One specific type of annuity, a fixed indexed annuity, actually allows you to gain partial market returns in a positive year while guaranteeing you won’t experience loss if the market is down for the year. Plus they may offer other income and death benefits.
Proper Asset Allocation
Beyond figuring out what types of assets to invest in, then you must think about allocations…how much of each. What percentage of equities, bonds (including types), CDs and cash, domestic versus foreign securities, annuities, real estate, inflation hedge, and other types of assets will best serve your purpose and help you toward obtaining your goals near- and long-term, whatever they may be?
That’s where things can get tricky. No one allocation is right for a person throughout their adult lives.
What is best for you now may not be in a few years. Proper allocations are based on many factors and elements, ranging from your risk tolerance (making huge returns won’t matter if you can’t sleep at night or don’t have time left to recover in the event of a market crash), age, amount of time till retirement, goals, health and expected lifespan, and more.
This can get pretty complicated. For many people, trying to create a properly diversified and allocated portfolio is not something they can do effectively.
This is one of the primary reasons to utilize a qualified financial advisor or retirement planner who can help build a portfolio designed to diversify your risk through proper allocation and risk management strategies that are based specifically on you and your needs.
Okay, you know you should diversify your portfolio, but you also know you should eat your peas and not have that extra five donuts for breakfast. Just like the donuts, your eyes glaze over when told what to do with your money.
So, let’s focus on the benefits of diversification to keep your attention.
Here are 5 benefits of having a properly diversified portfolio:
- Offers peace of mind. This can’t be overstated as a benefit. One of the most overlooked areas when it comes to investing is that of experience. While it might be great to obtain high returns, it is not such a great experience to lose sleep at night over your portfolio. A bad experience in investing can outweigh a potential higher return. Finding the right balance that offers peace of mind mixed with good returns is one of the goals of proper diversification.
- Reduces the impact of market volatility. A properly diversified portfolio helps reduce risk, and in turn volatility, which over time can increase returns.
- If you have a diversified portfolio you don’t have to constantly monitor the markets and be on alert of making moves in terms of your holdings. The very nature of allocation and diversification provides a potential safety net for your portfolio, so you can concentrate on other areas of your life on a day-to-day basis.
- Diversifying can help mitigate extreme losses to your portfolio. For example, if you are invested in equities only, a stock market decline of 10% or more (which happens more frequently than most realize) can cause real damage to your savings that might take several years or more to recoup. Simple diversification can reduce the losses in equities and provide gains in other areas which are usually less correlated, such as bonds, thus reducing your overall portfolio loss for the year.
- Provides the opportunity to invest in different asset classes. To address the risk of overweighting your portfolio, you must buy across asset types. From domestic to foreign, equities to bonds, and real estate to funds, a properly constructed portfolio forces you to invest in an assortment of asset types. This can make the experience more interesting while providing better risk management for the portfolio.
Nobel Prize winner and famed economist Harry Markowitz is well-known for his statement, “Diversification is the only free lunch in finance.” What this means is that you can gain the benefit of reduced risk in your portfolio while at the same time avoiding sacrificing much in the way of expected returns over a long period.
More simply stated, it “can” pay to diversify.
While diversification and proper allocation are something you should seriously consider if you aren’t already, it’s no easy feat to accomplish.
For most, this would best be left with a professional financial advisor or retirement planner who is familiar with constructing a diversified portfolio specifically for your situation, needs, and goals. One that incorporates risk management strategies that can protect your savings while allowing for the best chance to grow your money over time.
If you’d like, we can review your portfolio and help you optimize it to meet your future needs and goals while at the same time providing peace of mind during your retirement years.
If you’re ready to take the next step and talk to a team of financial advisors and retirement planners who put your interests first, Schedule a call today!
Let Us Help You Achieve the Retirement You Deserve!
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