Chances are you’ve heard the saying, “Don’t put all your eggs in one basket.” But do you know what that statement really means?
The concept isn’t too difficult to understand: Don’t put everything you have on one idea. But why not? And are you sure you’re not making this mistake?
As a retirement advisor in Greenville, SC, I’ve seen the effects of this more than I’d like. Remember this GE example we shared a few years back? Or what about “Audrey,” who had too much company loyalty back in 2008?
It’s important to remember that all investments carry some degree of risk. Whether investing for your current needs or for your retirement, diversification is almost universally touted as an essential ingredient for success. The reason is that it allows you to construct a portfolio that has inherently less risk for any level of return. High net worth investors are especially sensitive to the need for diversification, because the more you invest, the more you have to lose. By diversifying your investments, you make sure not to put all your eggs in one basket.
Diversification is another well-known, yet misunderstood phrase. As a retirement advisor in Greenville, SC, let’s review it’s meaning as seen within the large context of investment horizon, risk tolerance and asset allocation.
What Diversification Means
Diversification does not eliminate risk, nor does it guarantee against loss. The best we can expect from diversification is to reduce investment risk over the long-term without crippling performance. The power of diversification derives from 2 of its characteristics:
- You can achieve risk reduction by spreading your investments over a variety of different financial instruments, economic sectors, geographic locations and other categories that react differently to an event. The thinking is that when one market zigs, another market will zag due to a low correlation of returns. When successful, diversification helps you achieve positive returns in parts of your portfolio that offset losses in other parts.
- Diversification reduces unsystematic risk; that is, the risk associated with an individual security rather than the overall market. A market’s systematic risk cannot be avoided by diversification, but you can control your exposure to different markets through asset allocation.
The strategy of diversification is to identify and invest in different asset classes that are poorly correlated with each other. Correlation is measured on a scale of +1 to -1. A value between 0.3 and 0 indicates low correlation, while values below 0 demonstrate negative correlation.
When two markets have a correlation of 0, the price movement in one has no effect on the other’s price movements. If your portfolio is centered around stocks, history shows that certain asset classes, such as private equity, gold, real estate and hedge funds, are poorly correlated to the stock market.
This is a hard balance for DIY investors to accomplish on their own. At Global View, we have access to private investments that give clients more flexibility in constructing a diversified portfolio. (Read our recent blog post: The Highest Rated Fund Selection Fallacy.)
Investment Horizon and Risk Tolerance
Diversification is most effective in the long-term because it can take years for its full effects to be felt. Different markets have their own cycles of boom and bust, and their price movements don’t always occur on the same schedule. Thus, you might have to wait a year or more to see two poorly correlated markets diverge.
Diversification for retirement portfolios makes sense, especially if you are a decade or more from retiring, because as the horizon increases, you have more time for diversification to provide its benefits.
Everyone’s risk tolerance is different. Asset allocation allows you to tune a portfolio to your tolerance for risk, from seeking it out to avoiding it. At Global View, we review client portfolios on a regular basis to make sure their investment strategies remain in-line with their risk tolerance. (Read our recent blog post: Constant Vigilance to Improve Client’s Risk (And Return).)
To personalize your portfolio so that it reflects your overall risk tolerance, it isn’t enough to merely identify markets that are uncorrelated with each other. You can control the overall risk of your portfolio by deciding how much money to allocate to each asset type.
You can reap the benefits of diversification (in terms of reducing unsystematic risk) while controlling your overall risk exposure by carefully balancing your asset mix. You can then rebalance your asset allocations over time to adjust your overall risk.
You also can reshuffle your assets to compensate for changes in market correlations, which are not necessarily constant over time. For example, bonds are more correlated to stocks than they used to be, so your asset allocations should reflect the latest figures for market correlations.
How DIYers Often Get it Wrong
Using a benchmark is a useful way to track progress in your investments. But to work, you need the right benchmark!
The problem is few investors know how much risk to bear because techniques for doing so are flawed. Invalid risk assessments cause investors to take more risk during good markets (when value may be hard to find) and less during bad markets (when value may be abundant). Because this leads to panic selling (remember the Great Recession?), studies show investors leave about half of their returns on the table.
Investing isn’t a game. Your financial future is at risk. Big losses, especially as you near retirement, can be harder to recover from. Emotions tend to get involved when it’s your own money that you’re managing.
Talk with us! As a retirement advisor in Greenville, SC, we want to help. In our experience, we’ve seen a lot of retirement horror stories from investment mistakes and planning faux paus. Don’t be one of them. Get a conversation started and see if we’re the right fit.