Educated investors understand that there is a benefit to diversification. Setting aside grandma’s warning to not put “all your eggs in one basket”, there are clear advantages to investing broadly within and across different types of investments. Diversification is one of the keys to preserving the wealth that you’ve accumulated for your retirement. Let’s look at why it’s so important.
What is Diversification?
In practical terms, diversification involves owning investments which will respond differently to the same market or economic event. For instance, when the economy is growing, stocks tend to out-perform bonds. But when things slow down, bonds often perform better than stocks. By holding both stocks and bonds, you reduce the impact on your portfolio when markets swing one way or the other. The same holds true for other types of investments you could include in your portfolio, like bonds, real estate, cash and more.
Creating an Investment Mix
Let’s imagine that you have at your disposal 20 different investment types to use in your portfolio.* You can create an almost infinite number of “mixes” – from very concentrated in just one or two investments, to very well diversified across all 20 of them.
Now, let’s imagine that you’re looking at the historical performance of these different mixes – or “allocations” – over a fairly long time period (the longer, the better, in fact). And then you make a simple chart of their annualized returns, and the variability of those returns from month to month (the “standard deviation” of the returns, to use a concept from high school statistics). The returns for some mixes will be very volatile, while those of others won’t fluctuate much at all. On your chart, you plot the returns for these mixes on the vertical axis, and the variability of those returns (or risk) on the horizontal axis.
What would you ideally like to see in your chart? Well, high returns with no risk, right? That would mean a position on your chart that was in the upper left corner – representing high return on the vertical axis, and low risk on the horizontal axis.
The Relationship between Risk and Return
Look at the chart below. It plots the risk and return of several allocations over the 20-year period from January 2000 to December 2019.
What can we conclude from this chart? Well, two very important things:
First, we can see that there is no dot representing an allocation in the “ideal” position – the upper-left corner. What we see instead is that there are 5 dots plotted in what looks very much like a curve, and one dot all by itself below the curve.
The dots in the curve represent 5 different Springwater model portfolios – different combinations of the asset classes we use in our clients’ well-diversified portfolios.
The fact that they’re in a curve, or line, suggests that you could pick any one of them, depending on your desire for return or your tolerance for risk, and know that you’re doing the “best” that you can, given the available menu of investments.
Wait, what?! How do we know this is the best that you can do? Because there is no dot that lies above the curve! The curve represents a concept known as the “efficient frontier”. The efficient frontier is just a technical term for the line that represents the set of portfolios offering you the highest expected return for a given level of risk. A technical note: these are allocations made up of a specific set of investments. If we were to change the set of available investments, the curve would look slightly different.
Second, we can see that there is one dot that lies below the efficient frontier curve. The gray dot represents the performance of the S&P 500 Index (basically, large US company stocks) over this 20-year period. It reflects a single asset class, an undiversified portfolio.
An allocation (represented by a dot) that plots below the curve is considered “sub-optimal”. Why? Well, because simply by diversifying we could improve our portfolio’s performance for a given level of risk, or reduce our portfolio’s risk for a given level of return.
Look where the gray dot lines up on the horizontal axis. It’s at a bit less than 15%. Now look above the gray dot, and imagine that there aren’t just 5 portfolios making up our efficient frontier, but so many that their dots form a smooth curve. It would be possible to just move straight up from the gray dot to a point on the curve, right? And by doing so we would be getting more return for the same level of risk.
This is why some economists refer to diversification as “the closest thing to a free lunch”.
Maximizing your return for the level of investment risk you’re taking is a key to the preservation of wealth.
Don’t leave your future to chance. Contact our team at Springwater Wealth today to learn how we can help you develop a financial plan for your peace of mind.
Never the Best, Never the Worst
Now, it should be obvious that a well-diversified portfolio will never perform as well as the best-performing individual asset class.
When one investment type goes on a long-run of out-performance, like tech stocks did in the 1990s and US large cap stocks did in the aftermath of the 2007-09 Great Recession, some investors question the merits of diversification, and begin to lose faith. They see that their well-diversified portfolio generated lower returns than did the “star” performer.
But investment returns can change course very quickly. Investors with portfolios of only US tech stocks in the 1990s saw a negative annual return for the entire next decade from 2000 to 2009! Meanwhile, well-diversified investors lagged a bit in the 1990s, but dramatically out-performed in the next decade, as international stocks, bonds and real estate all beat US stocks.
Preserving Wealth in Retirement
One of the biggest investment challenges is managing portfolio withdrawals when stock prices are declining. For retirees, this is a very real risk. You’ve retired, and so are no longer contributing to your investment and retirement accounts – you’ve shifted from accumulation mode to distribution mode. At the same time, your investments in stocks are declining in value. Mathematically, this is the worst possible scenario – taking distributions from a portfolio that’s declining in value.
Since we know that the stock market typically experiences a significant correction on average once every seven to ten years, how can you minimize this very real risk? By ensuring that your portfolio has a mix of investments that are expected to perform differently over time, including high-quality bonds and cash (or cash equivalents).
Why? If you have high-quality bonds and cash in your portfolio, they will maintain their value even as the stocks you own fall in price. You can then sell some of your bonds and use the proceeds, together with your existing portfolio cash, to cover your distributions, allowing the stocks time to recover their value. At Springwater, we typically have one to two years’ worth of your anticipated distributions in investments that should not decline in value even when the stock market gyrates. A well-diversified portfolio, that includes bonds and cash in the investment mix, will help you preserve wealth when the stock market is volatile.
* In practice, Springwater typically uses between 15-20 asset classes in our clients’ investment strategies.
** The efficient frontier is a concept introduced by Harry Markowitz and others in 1952. Markowitz would go on to win the Nobel Prize in economics for this work.