Diversification Creates More Resilience Than De-Risking
When it comes to investing, few topics are as baffling as the topic of portfolio diversification. Investors saving for retirement often choose to reduce their exposure to stocks as they get close to their expected retirement date. Often, they do this by allocating more to bonds and less to stocks.
This can be a very wise move, of course. And when we pay attention to the difference between de-risking and diversification, we can realize an even greater benefit.
What is de-risking?
The explicit goal of de-risking a portfolio is to lower its volatility. De-risking is the process of adding low-volatility assets (like bonds) to a portfolio in order to reduce the volatility of the portfolio. De-risking may improve the diversification of the portfolio, but need not do so.
What is diversification?
Diversification is the process of combining assets that are not perfectly correlated in order to spread the risk of the portfolio across multiple sources. Diversification may reduce the risk of the portfolio, but need not do so.
We put a heavy emphasis on creating diversified portfolios. Why?
Because diversification provides investors with a proverbial “free lunch” whereas de-risking does not.
Remember, the goal of diversification is to spread risk across multiple independent sources. Ideally, in other words, your bonds will zig when your stocks zag. Even if we can’t count on that ideal scenario playing out every time, that’s the aim.
So, from the viewpoint of diversification we want the pieces of the portfolio to have two properties. First, we want them to be as uncorrelated as possible. Second, we want them to be balanced in the amount of volatility they have.
A tradeoff that we see many investors make when they build so-called “balanced” portfolios is that they prefer low-risk instruments like cash, CDs, money markets, short-term bonds, or so-called “total bond market” funds. The result, though, is that they sacrifice the “free lunch effect” by accepting less return for a given amount of portfolio risk.
We help our clients choose investments that work in tandem. This way, the whole is (literally) greater than the sum of the parts. Building a portfolio with diversification in mind can help increase your probability of reaching your financial goals, and we can help. Schedule a call with us to see if we can help you improve your diversification.