Diversification in Uncertain Times

If there is one thing to be learned from the last year in the stock market, it is the value of diversification. I think that when most people hear discussion of diversification they immediately tune out because they believe they already know what it means. After all, clearly all it means to be diversified is to own multiple stocks or mutual funds, right? – Not quite.

I have been hearing a lot of this lately: “I am never going to be able to retire; my broker told me that equities were the best place to put my retirement savings, now because of the economy my retirement account has shrunk to half of what it used to be.” This logic reminds me of a 14 year old who while mowing the lawn lopped off the sprinkler heads and then told his dad that it was the lawn mowers fault. The market doesn’t make mistakes, just like the lawn mower doesn’t drive itself over sprinkler heads – in both cases the problem is operator error.

First off, let me say that when it comes to investing for retirement you have options, every retirement planner or broker has a “sure-thing” strategy that will make you filthy rich and secure your estate for generations to come. A few of the most recent strategies I’ve heard about involve complicated bond and treasury investing (I could write this whole article on reasons to be leery of these guys and their “strategies” but I digress). Many people have sworn off of stocks because of the last decade and maybe rightfully so.

You don’t have to invest in equities to generate enough money for retirement. To perform accurate planning you will want to use a lower assumption for your lifetime rate of return and you will want to think about some other options to help you reach your goals. You could:

1.) Delay retirement a few years
2.) Choose to live on less in retirement
3.) Save more pre-retirement
4.) Leave less to your children
(Or there is the more humorous fifth option… die earlier.)

Whether or not you choose to invest in stocks is a complete individual choice. For the average investor, equity type returns can be captured through mutual funds. It’s important to keep an eye on the expense ratios but mutual funds are nice because the stocks or bonds held within the fund are being actively managed by professionals who spend all day making sure your investment is performing.

By looking through your mutual funds prospectus you can see what individual stocks or bonds make up that fund. When determining whether or not your total portfolio is diversified look and see if your funds overlap in their holdings. Often large mutual fund companies own similar investments in multiple funds. Also look to make sure that a wide array of business sectors as well as different market capitalizations are represented in your holdings. Of course you should also re-assess your risk tolerance as you reach new milestones in your life, your investment profile will not be the same at 50 as it was at 25. If you would like to learn more about diversification or if you would like to have a comprehensive review of your portfolio, please contact me.

Would diversification have shielded you from any losses over the last year? Probably not, the market as a whole moved too substantially to avoid all losses; but if you were properly diversified according to your age and risk tolerance you would have mitigated your total loss and ultimately preserved your nest egg.