{"id":3743,"date":"2020-03-31T06:00:51","date_gmt":"2020-03-31T13:00:51","guid":{"rendered":"http:\/\/springwaterwealth.com\/?p=3743"},"modified":"2020-07-30T23:06:30","modified_gmt":"2020-07-31T06:06:30","slug":"the-importance-of-diversification-in-the-preservation-of-wealth","status":"publish","type":"post","link":"https:\/\/springwaterwealth.com\/the-importance-of-diversification-in-the-preservation-of-wealth\/","title":{"rendered":"The Importance of Diversification in The Preservation of Wealth"},"content":{"rendered":"

Educated investors understand that there is a benefit to diversification. Setting aside grandma\u2019s warning to not put \u201call your eggs in one basket\u201d, there are clear advantages to investing broadly within and across different types of investments.\u00a0 Diversification is one of the keys to preserving the wealth that you\u2019ve accumulated for your retirement<\/a><\/strong>.\u00a0 Let\u2019s look at why it\u2019s so important.<\/p>\n

What is Diversification?<\/h2>\n

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.<\/p>\n

Creating an Investment Mix<\/h2>\n

Let\u2019s imagine that you have at your disposal 20 different investment types to use in your portfolio.* You can create an almost infinite number of \u201cmixes\u201d \u2013 from very concentrated in just one or two investments, to very well diversified across all 20 of them.<\/p>\n

Now, let\u2019s imagine that you\u2019re looking at the historical performance of these different mixes \u2013 or \u201callocations\u201d \u2013 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 \u201cstandard deviation\u201d 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\u2019t 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.<\/p>\n

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 \u2013 representing high return on the vertical axis, and low risk on the horizontal axis.<\/p>\n

The Relationship between Risk and Return<\/h2>\n

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.<\/p>\n

\"Rates<\/p>\n

What can we conclude from this chart? Well, two very important things:<\/p>\n

First, we can see that there is no dot representing an allocation in the \u201cideal\u201d position \u2013 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.<\/p>\n

The dots in the curve represent 5 different Springwater model portfolios \u2013 different combinations of the asset classes we use in our clients\u2019 well-diversified portfolios.<\/p>\n

The fact that they\u2019re 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\u2019re doing the \u201cbest\u201d that you can, given the available menu of investments.<\/p>\n

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 \u201cefficient frontier<\/a><\/strong>\u201d. 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.\u00a0 A technical note: these are allocations made up of a specific set of investments.\u00a0 If we were to change the set of available investments, the curve would look slightly different.<\/em><\/p>\n

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<\/a><\/strong> (basically, large US company stocks) over this 20-year period. It reflects a single asset class, an undiversified portfolio.<\/p>\n

An allocation (represented by a dot) that plots below the curve is considered \u201csub-optimal\u201d. Why? Well, because simply by diversifying we could improve our portfolio\u2019s performance for a given level of risk, or reduce our portfolio\u2019s risk for a given level of return.<\/p>\n

Look where the gray dot lines up on the horizontal axis. It\u2019s at a bit less than 15%. Now look above the gray dot, and imagine that there aren\u2019t 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.<\/p>\n

This is why some economists refer to diversification as \u201cthe closest thing to a free lunch\u201d.<\/p>\n

Maximizing your return for the level of investment risk you\u2019re taking is a key to the preservation of wealth.<\/p>\n

Don’t leave your future to chance. Contact our team at Springwater Wealth today to learn how\u00a0<\/span>we can help you develop a financial plan for your peace of mind.<\/span><\/span><\/strong><\/a><\/h2>\n

 <\/p>\n

Never the Best, Never the Worst<\/h2>\n

Now, it should be obvious that a well-diversified portfolio will never perform as well as the best-performing individual asset class.<\/p>\n

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.\u00a0 They see that their well-diversified portfolio generated lower returns than did the \u201cstar\u201d performer.<\/p>\n

But investment returns can change course very quickly.\u00a0 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!\u00a0 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.<\/p>\n

Preserving Wealth in Retirement<\/h2>\n

One of the biggest investment challenges is managing portfolio withdrawals when stock prices are declining.\u00a0 For retirees, this is a very real risk.\u00a0 You\u2019ve retired, and so are no longer contributing to your investment and retirement<\/a> <\/strong><\/span>accounts \u2013 you\u2019ve shifted from accumulation mode to distribution mode.\u00a0 At the same time, your investments in stocks are declining in value.\u00a0 Mathematically, this is the worst possible scenario \u2013 taking distributions<\/a><\/strong> from a portfolio that\u2019s declining in value.<\/p>\n

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?\u00a0 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).<\/p>\n

Why?\u00a0 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.\u00a0 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.\u00a0 At Springwater, we typically have one to two years\u2019 worth of your anticipated distributions in investments that should not decline in value even when the stock market gyrates.\u00a0 A well-diversified portfolio, that includes bonds and cash in the investment mix, will help you preserve wealth when the stock market is volatile.<\/p>\n

 <\/p>\n

 <\/p>\n

* In practice, Springwater typically uses between 15-20 asset classes in our clients\u2019 investment strategies.<\/p>\n

** 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.<\/p>\n","protected":false},"excerpt":{"rendered":"

Educated investors understand that there is a benefit to diversification. Setting aside grandma\u2019s warning to not put \u201call your eggs in one basket\u201d, there are clear advantages to investing broadly within and across different types of investments.\u00a0 Diversification is one of the keys to preserving the wealth that you\u2019ve accumulated for your retirement.\u00a0 Let\u2019s look […]<\/p>\n","protected":false},"author":2,"featured_media":3747,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_et_pb_use_builder":"","_et_pb_old_content":"","_et_gb_content_width":"","_mi_skip_tracking":false,"footnotes":""},"categories":[3,6,152,11],"tags":[159,118,140],"aioseo_notices":[],"_links":{"self":[{"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/posts\/3743"}],"collection":[{"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/comments?post=3743"}],"version-history":[{"count":0,"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/posts\/3743\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/media\/3747"}],"wp:attachment":[{"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/media?parent=3743"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/categories?post=3743"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/springwaterwealth.com\/wp-json\/wp\/v2\/tags?post=3743"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}