Common investment
knowledge suggests that “you shouldn’t put all your eggs in one basket.”
In effect, this
phrase is attempting to convey that you need to diversify.
In the
context of your finances, diversification is not just placing your assets into
random buckets with the hope that nothing bad will happen. Instead, you need to
allocate your assets in an optimal manner to achieve your desired results.
Diversification for Investing
The right mix of diversification will be unique to each investor based on your
preferences for risk and return.
Accordingly,
determining the appropriate blend of assets is the starting point in building a
diversified portfolio.
As an investor
you may be more risk seeking than others who are more risk averse and yet an optimal portfolio can be built for both preferences along the continuum of risk
and reward.
Additionally,
throughout your lifetime the diversification of your portfolio will naturally
change. That is, you should be more heavily exposed to riskier assets like
stocks, real estate, and emerging markets when you are younger because you need
the higher expected returns from these assets to grow your account.
Conversely, once you have accumulated wealth you may wish to use the money to fund your
lifestyle and you will need to shift your allocation to focus on income
generation and inflation protection.
Building a
portfolio consisting of dividend-paying stocks and investment grade bonds is a
simple solution to meet income-related goals.
Once living off your assets, you will typically withdraw up to 4% of your account balance annually
for living expenses.
If you are
curious to know how much money you will need to have in your retirement account
in order to live comfortably off of your assets calculate the following:
Divide your
anticipated annual income in retirement by 4% and this will give you an
estimate for the value of your nest egg.
For instance, if you want to live off of $100,000 annually
in retirement you will need $2.5 million in savings to build that lifestyle.
Even though
you are taking a 4% draw on the account, it is reasonable to expect that your portfolio
will continue to grow modestly as long as the 4% is taken from dividends and interest
while the remaining balance is left invested to grow at a historical rate of 6%
for a traditional diversified portfolio.
In recent
years the advent of Robo-Advisors has opened the door for everyone to have
access to diversified account management.
For example,
apps like Acorns allow for you to invest spare change, or “round ups,” on
purchases by linking your credit or debit card as well as making scheduled and unscheduled
contributions and withdrawals.
In other
words, since Acorns offers a taxable brokerage account product you are able to
deposit and withdraw as much money as you want whenever you want without
penalty. As a result, this product can be an excellent savings tool for both short-term financial goals and long-term retirement plans.
Similarly,
investment products like WealthFront and Betterment offer low-cost diversified
portfolio solutions for individuals who wish to contribute more money up front.
In the end,
whether you invest with Acorns or through a product like WealthFront or
Betterment your money is being invested efficiently in a diversified portfolio
based on the precepts of Modern Portfolio Theory (MPT).
Under the
framework of MPT, investor money is optimally allocated and diversified to
maximize return for a given level of preferred risk. Dr. Harry Markowitz won
the Nobel Prize in economics for designing this investment system which allows
for investors to target expected returns and risk during the portfolio
construction and diversification process.
By tailoring
your portfolio returns to target a certain level you can plan for an expected
future portfolio value at a certain date. Meanwhile, you are keeping your risk at
a tolerable level through the beauty of diversification.
To this day,
Markowitz’s pioneering idea is the framework by which all investment diversification programs are designed.
Key Takeaways on Diversification
While
diversification is not a perfect solution to protect your portfolio from bear
markets, it will help you safeguard and grow your money efficiently over time.
Whether you
have most of your savings tied up in cash, your company stock, a few random
mutual funds, or have yet to start investing there are plenty of accessible
solutions that can help you build a diversified account.
By diversifying
your portfolio your expected returns can be structured to increase your odds of achieving financial goals over any time frame.
As always,
if you have questions or comments, feel free to send me a message. Thanks for
reading.
John
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