Is Your Investment Portfolio On Thin Ice?
Ben handed over a statement of his current portfolio and I noticed something right off the bat. I set down the paperwork and asked them what they know about diversification. They both said they have heard about it, know it is important, but neither really understood how or why.
So, I asked Ben and Mary to imagine a scenario that I will share with you. Imagine yourself in the middle of a cold, frosty ice-covered lake. Not solid ice... Im talking about thin ice that is beginning to crack. What is your best move? Even if you havent found yourself on thin ice (literally) weve all seen the videos of cold-water rescuers sliding along the ice on their stomachs, distributing their weight over a wide area.
You see, if you stand on one leg on thin ice, all of your weight is concentrated on that one point, and if the ice under that one foot is compromised, you, my friend, are going to be wet and cold. Even if you stand on both feet, but happen to be standing on a weak spot, you are going in the drink. The same goes for having all your investments in one asset class. If that asset class takes a hit, your whole portfolio is going for a swim. The goal of diversification is to distribute your financial weight across many asset classes, so if one area of the ice is weakened it is less likely your whole portfolio will be pulled down at once. Other areas will support you and preserve the integrity of your portfolio.
Disbursing risk is especially important in financial planning, as there is no way to know for certain where the weak spot is. And putting all your weight in one area usually means it is only a matter of time before the ice cracks and you are soaked.
I could see by the looks on Bens and Marys faces that they understand the danger they are facing, and Im assuming you get the picture as well, so Ill stop with the illustration and move on to the details.
When you look at a properly diversified portfolio, you need to make sure that diversification is not only among different asset classes, but industries and positions that are not correlated with each other and have different risk levels. Having four pickup trucks in different colors does not give you a diversified collection of vehicles; all four trucks have the same strengths and weaknesses.
A diversified portfolio often includes four to five main asset classes depending on the size of the portfolio: domestic stocks, bonds, short-term investments, alternatives, and international stocks. Each serves a different purpose, and helps to protect your overall portfolio from specific risks that another asset class may be susceptible to. Domestic stocks often provide growth, but with that growth comes higher risk. Oftentimes this higher risk is offset by bonds, which tend to be more predictable, and can provide regular interest income. Bonds have less growth potential, but they are often considered a less risky asset class.
Both domestic stocks and bonds offer long-term investment options. So, it is often advisable to have an option that focuses on short-term needs, and provides the ability and ease to access money without disrupting a strategy. This need can be served by investment vehicles like money market funds and short-term treasuries. I know the return isnt great, but the money is easily available.
Alternative investments should also be included in a diversified portfolio. One significant advantage to incorporating alternative asset classes into any successful investment plan is that alternatives have a low correlation with other standard asset classes, such as domestic equities, international equities and bonds. Alternatives should not be a significant piece of your allocation, usually up to only about 10 percent. Investments in commodities, precious metals, and real estate investment trusts are some typical examples of alternatives and because of the inverse correlation with traditional assets, they provide a good hedge against inflation.
The last asset class often used in a successful, diversified portfolio is often overlooked: international equities. These stocks, many times, perform differently than US-based stocks. They are able to capitalize on different opportunities that might not be available to domestic stocks, so this gives investors a good option for growth, while balancing a different array of risk than domestic stocks.
Ben and Mary got it. They realize that their strategy is heavily weighted in US equities, which does not give them the diversification needed for a successful investor. I explained to Ben and Mary that we need to construct a portfolio for them based upon their acceptable risk and allowable drawdown. Drawdown is the amount of swing in a portfolio, or movement from a high to a low. While their current strategy, invested in US equities, may have performed pretty well as of late, it suffered a catastrophic drawdown of about 55 percent during the financial crisis of 2007. After a candid conversation to review their goals, their time line for retirement, comfort level for risk, and allowable drawdown, we reallocated them to 40 percent domestic equities, 30 percent fixed income, 15 percent international equities, 10 percent alternatives and 5 percent in short-term treasuries. Each and every sector has built-in downside risk triggers in the event of a sector meltdown.
Folks, risk tolerance is different for everyone, but the need for diversification is not. If you are properly diversifiedgreat. If you are not, now is the time to make sure your portfolio is properly diversified and make sure you have an emphasis on minimizing drawdown and loss.
It truly is the best way to help protect you from the dangerously thin ice that we often see in the financial world.