Portfolio Diversification Is Necessary to Keep Your Assets Safe Into Retirement

Portfolio Diversification Is Necessary to Keep Your Assets Safe Into Retirement

Read any articles about the financial well-being of American households and it’s clear that they don’t paint a pretty picture. Nearly 80% of households live paycheck to paycheck, with limited ability to save money for retirement or even for an emergency. Even though the average household has just under $9,000 in the bank, over 60% of households would have difficulty paying for an unexpected $1,000 expense. And although the average amount of money held in a 401(k) retirement account is $95,600, that’s nowhere close to enough to survive on in retirement.

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That means that much of the financial advice that is out there is targeted towards a very small percentage of the population. Still, for those who have saved up money for retirement with the hope of retiring comfortably it is vitally important to follow sound advice. Not taking the effort to protect your retirement savings will almost guarantee that decades worth of saving and investment will go to waste.

Portfolio Diversification Is a Necessity

To those who look at surging stock market numbers and dream about how large they can grow their portfolios, it can be tempting to go all in. While that may not hurt your portfolio in the short run, once stocks start to turn south you can get badly burned.

The time to diversify your portfolio is before that downward turn, and that takes discipline. You may have to forgo some short-term gains in order to protect your portfolio for the long term, but that’s why you’re investing, not gambling. Investing is a long-term game with a decades-long time horizon. Chasing short-term gains at the expense of possibly losing big is being penny wise and pound foolish.

The asset allocation of your portfolio can and should change over time too. While buying and holding is a popular investment strategy for more and more people today, failing to diversify your assets in response to changing market conditions can leave you susceptible to big losses. While that may not be a problem for those early in their careers who have decades still to recover, for those nearing retirement a loss of 20, 30, or 50% could be catastrophic.

How to Diversify

Diversification strategies are numerous, and ultimately the decisions about allocation are up to individual investors and their risk appetite. But the general principles remain the same. Diversifying your assets can protect against inflation, currency risk, default risk, geographic risk, and financial crisis. Each asset in your portfolio has its own advantages and disadvantages with regard to each one of those risks.

Stocks have traditionally been the primary means to gain asset value. And certainly when stocks are on a tear it is hard to compete with their ability to appreciate in value. But when the economy turns south, stocks follow. That downside can in some cases more than outweigh the upside.

Bonds have traditionally been the primary means of diversifying a portfolio away from stocks. Many investment plans will gradually draw down the percentages of stocks they hold and increase the number of bonds they hold as the investor grows closer and closer to retirement. The downside of bonds is the risk of default, and the higher the return on the bond the greater the risk of default becomes. That hasn’t been too much of a problem in recent decades, but with interest rates potentially set to rise significantly in the next couple of years, default risk could return with abandon.

With both stocks and bonds having done so well in the 1980s and 1990s, many investment advisers never thought to advise their clients about any further diversification or asset protection. It was assumed that stock and bond markets would continue to remain strong. But so far in the 21st century stock markets have consistently underperformed vis-a-vis their long-term averages.

Most investment advisers assume a return of about 7% annually for a stock portfolio that seeks to match the market. But since the beginning of the century stock markets have gained at an annualized rate of less than 5%. The Dow Jones has returned about 4.99% per year and the S&P 500 4.14% per year. That’s just barely above the government’s published inflation rates, meaning that real returns are 2% or less for many investors.

Contrast that with gold, which has seen a 9.02% annualized average since the beginning of the century and you realize that there are better opportunities out there for diversification. Gold not only has made great gains over the past two decades, but it also continues to act as a great hedge against inflation and financial crisis. When financial conditions show signs of deterioration, as they do now, investors flock to gold to protect their assets.

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With a gold IRA investors can even transfer existing retirement assets from 401(k), IRA, TSP, or similar accounts, allowing them to lock in gains from their stock and bond holdings and protect those gains when markets begin to decline. But again, diversifying into gold has to be done before the major crash occurs. Investors today have had a year of warning that stock markets are on shaky ground. They won’t have forever before the major decline kicks in, so time is of the essence.