Friday, 23 September 2016

Why Diversification Matters part 2

The primary goal of diversification isn’t to maximize returns. Its primary goal is to limit the impact of volatility on a portfolio. To better understand this concept let us consider some hypothetical portfolios with different asset allocations. We have looked at the average annual return for each hypothetical portfolio from 1926 through 2015, including reinvested dividends and other earnings.

The most aggressive portfolio - comprised of 70% domestic stocks and 30% international stocks, had an average annual return of 10%. Its best one-year return was nearly 163%, while in its worst year it would have lost nearly 68%. That’s probably too much volatility for most investors to endure.

Changing the asset allocation slightly, however, tightened the range of those swings very volatile swings without giving up too much in the way of long-term performance. For instance, a portfolio with an allocation of 49% domestic stocks, 21% international stocks, 25% bonds, and 5% short-term investments would have generated average annual returns of almost 9% over the same period, albeit with a narrower range of extremes on the high and low end with a best single year performance of 109% and a worst year of -52%. When looking at the other asset allocations, adding more fixed income investments to a portfolio will slightly reduce one’s expectations for long-term returns, but may significantly reduce the impact of market volatility. This is a trade-off many investors feel is worthwhile, particularly as they get older and more risk-averse.

Factoring time into your diversification strategy

People are accustomed to thinking about their savings in terms of goals: retirement, education, a down payment, or a vacation. But as you build and manage your asset allocation—regardless of which goal you’re pursuing—there are two important things to consider. The first is the number of years until you expect to need the money—also known as your time horizon. The second is your attitude toward risk—also known as your risk tolerance.

For instance, think about a goal that’s 25 years away, like retirement. Because your time horizon is fairly long, you may be willing to take on additional risk in pursuit of long-term growth, under the assumption that you’ll usually have time to regain lost ground in the event of a short-term market decline. In that case, a higher exposure to domestic and international stocks may be appropriate.

But here’s where your risk tolerance becomes a factor. Regardless of your time horizon, you should only take on a level of risk with which you’re comfortable. The other thing to remember about your time horizon is that it’s constantly changing. So, let’s say your retirement is now 10 years away instead of 25 years—you may want to reallocate your assets to help reduce your exposure to higher-risk investments in favor of more conservative ones, like bond or money market funds.

Once you’ve entered retirement, a large portion of your portfolio should be in more stable, lower-risk investments that can potentially generate income. But even in retirement, diversification is key to helping you manage risk. At this point in your life, your biggest risk is outliving your assets. So just as you should never be 100% invested in stocks, it’s probably a good idea to never be 100% allocated in short-term investments if your time horizon is greater than one year. After all, even in retirement you will need a certain exposure to growth-oriented investments to combat inflation and help ensure your assets last for what could be a decades-long retirement.

Regardless of your goal, your time horizon, or your risk tolerance, a diversified portfolio is the foundation of any smart investment strategy.

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