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Stop Being So Basic and Start Diversifying: Part 1

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. 

By starting to invest as soon as possible through an IRA, 401K, or even a brokerage account you will put the odds in your favor of compounding your starting value and future contributions to a meaningful sum like $2.5 million.

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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