We all know it’s important to plan ahead to avoid running out of money in retirement. While there’s no one right answer for everyone, there is one principle that can help guide your investing decisions: diversification.
Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.
Here is why regardless of your goal, your time horizon, or your risk tolerance, a diversified portfolio is the foundation of any smart investment strategy – and tips on best practices getting started.
A family vacation home, joining that country club, a new car… What do you want to achieve in retirement? The more specific and realistic your goals are, the better prepared you’ll be when planning and executing them. The next step is identifying revenue streams to help you meet those goals.
The reason why millionaires are able to generate so much wealth, is because they have multiple income streams. In fact, research shows that on average, millionaires have 7 different income streams. So why would you “put all your eggs in one basket” per se?
Start by determining your potential sources of retirement income, and how much income they are likely to provide in retirement. Common income sources include:
- Guaranteed Income (i.e. Social Security, Annuities)
- Pension plans (i.e., defined benefit plans)
- Retirement savings, including 401(k), 403(b), and 457 plans
- Other nonretirement savings, including brokerage accounts, savings accounts and certificates of deposit (CDs)
Secondly, diversify these revenue sources. Because each retirement income category represents a different type of income, and mitigates different retirement risks, diversifying your retirement income across all three can help you generate income in retirement that may last a lifetime. These categories include:
- Dividend: Equity income investments.
- Interest: Bond and fixed income investments.
- Lifetime: Social Security and pensions.
Having multiple sources of income—including a portfolio structured to include an immediate annuity, a systematic withdrawal program, a bond ladder, a CD ladder, or a combination of these investments—can help safeguard your income if interest rates fall or one of your investments delivers less-than-expected returns.
Asset allocation is the process of deciding what percentage of your assets to allocate to different kinds of investments. This can be done in many ways and the right way for you could be unique. Some people like to keep it simple, while others prefer a more complex solution that may include factors such as your income and risk tolerance.
When choosing how to invest, consider both short-term and long-term factors.
- Cash flow needs: Are you saving for a down payment on a home? Building an emergency fund? Budgeting for daily expenses?
- Risk tolerance: How comfortable are you with potentially losing money in the market? If you’re risk-averse, look at low-cost options like savings accounts or CDs. If you’re more willing to take risks and embrace volatility, consider investing in stocks or funds that track the stock market (e.g., S&P 500 Index).
- Investment horizon: How long will your investment last before it’s spent? Do you need regular access to your money during this period—for example, if there is an emergency expense—or can it sit untouched until needed later on down the road? The longer your investment horizon is, the less liquid (easily converted into cash) it needs to be.
Regardless of which method you choose, it’s important to know that asset allocation is a long-term strategy and should not be changed often.
Your retirement plan gives you the ability to invest in a wide variety of asset classes. With financial markets in constant motion, you’ll want to strive to have a balanced portfolio to help you mitigate risk.
The primary goal of diversification isn’t to maximize returns. Its primary goal is to limit the impact of volatility on a portfolio. Any investment portfolio will be subject to a certain amount of volatility over time. A portfolio’s exposure to volatility can and needs to be managed to prevent permanent loss of capital, or temporary impairment.
By spreading a portfolio across a number of asset classes, the entire portfolio won’t be subject to the volatility of any one asset class. The less correlated the investments in a portfolio are, the lower the volatility will be. Some assets are negatively correlated which can reduce portfolio volatility even more. For example, gold is seen as a safe haven, which means the gold price often appreciates when riskier assets like emerging market bonds see their prices fall.
To summarize, the more a portfolio is diversified across different asset classes and strategies, the more volatility can be reduced.
A well-diversified portfolio contains a mix of investments, such as stocks, bonds, cash and alternative investments like real estate or commodities. Diversifying your portfolio is one of the big key things that you can do to decrease risk.
When it comes to asset allocation and portfolio diversification, it is best to work with a trusted and experienced financial advisor so you can ensure that you settle on a method that best matches your age and investment goals.
While a diversified portfolio can still lose money, it can help to hinder your losses by decreasing overall investment risk.
At CKS Summit Group, we believe professionally managed tactical stock market and non-stock market portfolios can provide healthy, long-term upside growth potential. It can also be very effective at preserving principal while allowing for a high degree of downside risk protection. Contact us today to set up your complimantary strategy session.