fbpx

We are a fiduciary firm!

(818) 887-6443

[email protected]

20335 Ventura Boulevard, Suite 125

Woodland Hills, CA 91364

Diversification—The Key To Protecting Your Retirement!

As a financial professional, one question that I often get asked is which direction I believe the market will go next. For the last six months, I’ve been believing (and still do) that the market will make a turn for the worse and even has potential for another severe correction.

Although I felt this was likely to occur before the Dow Jones reached the 10,000 level, I still believe that the Dow could fall to 6,500 once again. On the other hand, I am aware that there are many folks reading this article who will think I’m crazy and that the worst is behind us. I want to remind them that this is what most people thought before each of the multiple crashes of the last decade.

Wouldn’t it be nice to have a crystal ball though? I’ll be the first to admit that no one, including me, knows for sure which direction the market will move next or where it will actually finish by year’s end. What I do know is this: your portfolio should not suffer regardless of where the market winds up. Investors need to protect themselves regardless of where the marked heads and the best way to accomplish this is through proper diversification.

Many investors believe that, since they own stocks or bonds with many different companies, they are properly diversified. Well, let me ask you: if all of your money is in stocks and the stock market crashes, does it matter which stocks you own or will they all most likely drop in value? What about the bond market? If bonds fall out of favor, does it matter which bonds you own or will most of them tend to drop in value? This same principle appears to hold true for real estate, precious metals and multiple other investments as well.

In my decade of coaching retirees on their finances, I have observed that there are three areas that many retirees tend to lack diversification in. The first is stocks, the second is bonds and the third is banks. I discuss each area below.

Stocks

In the last decade, many individuals who had a sizable portion of their portfolio in stocks learned the hard way that they were not properly diversified. I have often wondered why so many people lost so much money in the stock market, and I believe it is because many investors got addicted to the bull market of the ’80s and ’90s.

The media and various financial publications created a lot of hype about the rise of the stock market and the tech industry which made it very difficult for investors to do any kind of unbiased research. Articles like “The Five Best Stocks for the New Year” and “The Most Popular Mutual Funds for 1999” filled the racks as investors continued looking for the next Microsoft-type of investment. In this kind of environment, it is very difficult for the average investor to invest logically and not emotionally. In fact, I believe that many financial advisors got caught up in the hype as well even though one of the primary reasons for having a financial advisor in the first place is to take the emotion out of investing.

The tech bubble expanded for a long time during the late ’90s and the market increased faster and faster in a shorter time than at any other point in history. Price/Earnings ratios often exceeded 35 or 40, which is extremely high! When the bubble finally burst in 2000, it wasn’t surprising that many average investors and retirees lost a lot of money. And it was because they were not diversified enough and had too much money in the stock market.

How much should someone have in the market? The answer will depend on a number of factors, but the two most important are: how much you can afford to lose and your age.

Generally speaking, you shouldn’t invest more in the market than you can afford to part with. I speak with many retirees week in and week out who feel compelled to have money in the market just because a financial planning textbook says they should. If a retiree can accomplish their retirement goals with their current portfolio, why should they gamble? During retirement, preservation and keeping pace with inflation may be more important than growth. There is no rule that says someone is required to have any money in the market at all.

However, if a retiree can’t fathom being completely out of the stock market, what is a good amount to invest in it? A good rule of thumb is the “Rule of 100.” This decades-old rule says that, if someone subtracts their age from 100, the answer is the suggested maximum percentage of their portfolio that they should have in the market. For example, if they are 65, then they probably don’t want to have more than 35% (100-65) in the market. Likewise, if they are 80, they probably don’t want to have more than 20% (100-80) in the market.

As I write this, the stock market has increased by an unbelievable 65% during the last eleven months! It’s tempting to get caught up in the excitement of the increase and buy, buy, buy. Logically speaking, though, if the stock market goes up fast, then a little faster, and then really, really fast, what is likely to happen next? It is likely to have a correction, and history agrees as well. Though no one knows for sure, with proper diversification a retiree should be fine either way.

Bonds

While many retirees avoid the stock market because they can lose money, they will often turn to bonds because bonds are supposedly safe. Don’t misunderstand me, bonds are generally safer than stocks but many retirees I speak with feel that since their portfolio is in bonds, they can treat it with less care than if their money was in the stock market. Your money can be lost with bonds like with any other investment and retirees need to be aware of how bonds function, especially if they have bond funds.

Bonds offer two very important guarantees. First, they guarantee a certain interest rate that will remain constant for the life of the bond. Second, they guarantee that as long as you hold your bond to the maturity date, your principal will be returned.

However, between the time an investor purchases the bond and the maturity date, all bets are off when it comes to the value of the bond. If an investor needs to liquidate the bond prior to maturity, they may be able to sell it for more than they purchased it for or they may even take a loss.

Many retirees I meet with own bond funds, which function differently than bonds. With a bond fund, you lose the two most important guarantees that come with bonds. First, bond funds don’t guarantee a specified interest rate, and second, they don’t guarantee that you will ever get your principal back. Therefore, if the bond market falls out of favor for whatever reason, both bonds and bond funds may drop in value. However, if a retiree owns a bond, this would be a paper loss as long as they hold the bond to maturity, whereas if they own a bond fund, it may be a permanent loss.

This is not to imply that one is better than the other as there is a time and place for both. However, many retirees that I speak with feel that their portfolio can’t lose value because they own bonds when in fact they own bond funds. It is important to know what type of bonds or bond funds you own so you don’t have a false sense of security.

For a more detailed explanation as to how bonds and bond funds function read the article titled What Do You Mean My Bond Lost Value?.

Banks

There is yet another group of retirees who want nothing to do with stocks or bonds, or for that matter, anything else that has potential for loss. Although some of these folks got out of the market before it was too late, my experience has shown that most of the investors who fall into this category lost a good chunk of their retirement before getting out. Because they’ve been burned, they feel that they must have their money absolutely, 100% safe, and put it all in the bank.

Well, is money in the bank absolutely safe? The answer depends on how you look at it. It is safe from the market risk that is associated with stocks and from the interest rate risk that is associated with bonds. But there is another type of risk is often overlooked, one that retirees probably overlook most often. What is this risk? It is the risk of inflation.

In inflation risk, inflation will cause the cost of goods and services to go up faster than your retirement dollars, which will cause a loss of purchasing power. Most retirees that I meet with don’t realize what inflation does to the value of the dollar over time. Today’s interest rates are among the lowest in history. After retirees pay the taxes on their bank interest, they are most likely going backwards every year because of inflation.

About fifty years ago, the average life span in retirement was two to five years. Today, folks retiring can expect to live twenty years or more. Therefore, inflation may substantially affect their retirement. The problem is that they wouldn’t even recognize this erosion of buying power until sometime down the road when they need more income.

Inflation has typically averaged 3% to 4% per year. Because of this, over a 20 year period, the dollar may lose two-thirds to three quarters of its value making it only worth $.25 to $.35. Practically speaking, this means that someone retiring today may need three to four times more income in twenty years then they do today just to maintain their lifestyle. And, if you think this is far-fetched, remember the ’80s and I’ll bet you can think of some personal examples of goods and services that cost three to four times more today than they did back then.

So what is recommended for retirees who keep all of their money in the bank? Put it back into the market, cross their fingers and toes and hope they keep up with inflation? Not at all! There are actually a number of conservative options available that are designed to keep pace with inflation and in some cases, are just as safe and even insured.

A discussion of these conservative options is outside the scope of this article and would take an entire book to thoroughly cover. Therefore, I am in the process of writing a book which will explain what these options are, along with the characteristics of each.

If you believe that your portfolio is not diversified enough and would like to know what options may be better for you than your current investments, please feel free to contact me to schedule a Free Financial Physical.

 

Services are provided in surrounding cities including...