Diversification is a cornerstone of prudent retirement planning, but it's important to understand that it comes with its own set of challenges. There’s a famous quote in the financial planning industry, that "diversification means always having to say you're sorry." This means that in a well-diversified portfolio, there will always be something underperforming. In this blog post, we'll explore the concept of diversification, its types, and the benefits it offers, while emphasizing the need to manage your emotions when it comes to underperforming aspects in your investments.
Diversification: Your Key to Financial Safety
Diversifying your retirement portfolio means spreading your investments across various asset classes, industries, and geographical regions. The primary goal is to reduce risk, but it can also help maximize returns. Diversification is your insurance against the failure or underperformance of any single investment or a market downturn that could have a catastrophic impact on your overall portfolio. Below we’ve included a Callan chart that quantifies these benefits.
As you can see, the white boxes representing a diversified basket of holdings, are neither the highest nor lowest returners in any given year, but since ‘08, it has had the best risk-adjusted returns (see far left columns).
Beyond the various asset classes, there are many other forms of diversification that need to be considered:
- Sector Diversification: Within each asset class, maintaining diversity prevents sector-specific conditions from adversely affecting your holdings.
- Strategy Diversification: Don't put all your eggs in one strategy basket. At our firm, we use a combination of passively managed strategies and actively managed strategies. This means, if there is one strategy that isn’t pulling its weight in a certain environment, other strategies will hopefully be performing better.
- Time Diversification: Account for time in your investment decisions. Some asset classes are time-dependent, especially in the world of fixed-income. Consider your retirement timeline and risk tolerance when making choices.
- Geographic Diversification: In our globalized world, there are investment opportunities worldwide. Investing in securities from different regions reduces exposure to regional risks. This has been particularly challenging to commit to recently as international equities have underperformed their US counterparts for almost 13 years (see below). Eventually, internationals will have their day in the sun, and as you can see, it may last a heck of a lot longer than a day...
The Benefits of Diversification
Efficiency of Risk vs. Return: A diversified portfolio reduces overall risk, allowing you to achieve an optimal return profile for a given risk tolerance. This takes time and commitment, as the Callan chart referenced earlier illustrates, returns in various asset classes vary wildly on a year-to-year basis.
Smoother Investment Experience: As you age and rely on investments for retirement income, diversification becomes crucial for reducing stress. A younger investor with a longer time horizon has the ability to take more outsized risks, if desired. But diversification is a way to smooth out the ride and reduce the downside exposure of an investment portfolio.
The chart below illustrates if you were to allocate $10,000 annually to the best and worst performing asset classes of the previous year, with the benchmark being a diversified portfolio. Investing in the best performing asset class is what we refer to as “performance-chasing” and it is a key detractor of a retail investor’s performance.
Are Your Investments Adequately Diversified?
Diversification does allow for adjustments based on market conditions and risk tolerance. There is no set rule that you must maintain a certain level of diversification, especially in your active accounts. There will be time periods, for instance, in which it may be prudent to underweight or eliminate certain asset classes. For example, in early 2022, it was apparent we may be in a prolonged increasing interest rate environment, which made owning longer duration bonds less attractive, and many of our active strategies became underweight this type of fixed income.
The purpose of the blog is to remind you that underperformance in certain aspects of your portfolio is a natural consequence of diversification. Diversification isn't about avoiding underperformance entirely, but about ensuring that your overall portfolio remains resilient through all market conditions. So, embrace diversification, manage underperformance wisely, and secure your financial future with a well-diversified retirement portfolio.