Diversification: A Smoother Ride to a Financially Successful Retirement
Ever ridden in a car with worn out shock absorbers, or a motorcycle without any shocks at all? Every bump is jarring, every corner is a little frightening. It can be a scary ride, even for experienced drivers. We believe that owning an all-equity portfolio, a portfolio without any bonds or diversifiers, can also make for a scary ride.
In a motor vehicle, the suspension system keeps the tires in contact with the road and provides a smooth ride for passengers by offsetting the forces of gravity, propulsion, and inertia. You can drive a car with a broken suspension system, but it will be an uncomfortable trip and the vehicle will be harder to control, particularly in difficult conditions. Throw in the risk of a breakdown or running off the road altogether, and there’s a real chance you may not reach your destination at all.
In the world of investment, a similarly bumpy and unpredictable ride can await those with undiversified portfolios, or portfolios without the shock-absorbing effects of protective assets like fixed income. Even greater treachery can occur when you constantly tinker with an allocation based on the news of the day, or someone’s forecast for tomorrow. Naturally, when the stock market is reaching new heights and the roads you’re driving on are straight and smooth, there’s a sense of comfort and control: everything is fine. Yet it’s harder to stay on the road, and therefore harder to reach your destination, during sudden turns, bumpy pavement, and changing road conditions. And keep in mind the fix for your portfolio breaking down is unlikely to be as simple as calling a tow truck.
For these reasons, we believe that the smart thing to do is to diversify, spreading your portfolio across different asset classes, securities, sectors, and even countries. That also means identifying the right mix of investments (e.g., stocks, bonds, real estate) to align with your risk tolerance, yet matches the financial destination you are aiming for. Using this approach, your average returns from year to year may not match the top performers in your portfolio, and may look inferior to the returns your next door neighbor claims he is making. However, they are intended to insulate you against catastrophe, against the unexpected. Can you afford to weather another market downturn like the one that occurred in 2008? In calendar year 2008, the market dropped by more than 36%, and many never recovered. A skeptic might suggest that 2008’s decline was atypical. However, keep in mind that since 1928, the S&P500 has declined 20 times by 20% or more. That’s once every 4.4 years. Are your ready for the next downturn?
In retirement investing, there is no tow-truck to call after a catastrophic breakdown. After the damage has occurred, it can be permanent - unlike a repairable car. Thus, your portfolio management requires a change in strategy, coupled with a change in mindset. In our opinion, reducing your allocation to stocks and increasing your allocation to bonds and diversifiers is a way to preserve your assets against the unexpected, and to protect those assets in order to maintain the income stream you rely on. No longer should the investor’s mindset be to “beat the market” or to achieve the highest available returns for that year. Instead, the investor needs to focus on lessening volatility, achieving a targeted level of income from the portfolio, and avoiding drawdowns on depreciated assets that have not had enough time to recover.
Retirees we work with share the same goals. They want to maintain a lifestyle, and they want financial peace of mind. They often care less about achieving the highest returns, and care more about the certainty of the income from their portfolios that affords them their lifestyle. Most do not have a pension, the costs of healthcare are considerable (and climbing), and many will live much longer lives than they ever thought. (A dear friend of mine just lost his father this year: he was 106 years of age. What if you live past 100?) With many stocks trading at all-time highs and interest rates still near historic lows, the case for diversification – with an allocation to bonds - remains solid as ever. Here are just a few reasons why we believe bonds remain an important protection component in a globally-diversified portfolio:
- Bonds provide semi-annual interest payments and give clients the ability to hold their investments until maturity without having to worry about daily price fluctuations. When bonds are held to maturity, the investor gets something in return that stocks cannot offer: a known return on their capital, and a promise that they’ll get their money back.
- To protect against rising interest rates and increases in inflation, we stagger the maturities of the bonds (bond laddering) so that proceeds from maturing bonds can be reinvested at the then higher interest rates. This can result in increasing levels of annual income.
- Bonds essentially de-risk the portfolio, smooth the road, and can help insure an investor that they will reach their investment destination without an unexpected portfolio catastrophe. When the stock market is going up, investors often fret over the comparatively lower returns of their bond allocation. Some wonder why they own bonds at all. However, when there is a stock market correction and the downturn is prolonged, the value of bonds are realized and appreciated. Like a tow truck that comes to the rescue of a broken down car, the value of bonds is sometimes appreciated most after a stock market breakdown.
- An allocation to bonds protects many years’ worth of retirement income so that, if the stock market corrects materially and takes several years to recover, the investor has an income to draw from the bond allocation alone… rather than draw down stocks or stock funds that haven’t had enough time to recover. Not only does this leave the investor with peace of mind that the income supporting their lifestyle will remain uninterrupted, giving the other growth assets time to recover, but if the investor wishes to invest more in equities while the market is depressed there is capital available to make those additional equity investments.
Since the Great Recession of 2008, and now looking back ten years after that painful decline in the markets, investments in bonds and many diversifying instruments can look unimpressive against their stock market counterparts. The stock market has essentially gone straight up since March of 2009, and the pain of that correction has slowly declined with each year the US stock market has provided an impressive return. Yet the tide will turn. The economy will change and thus the investment landscape will change. When you are young and have years of compounding returns ahead of you, plus a paycheck to fall back on, taking higher portfolio risks can make good sense. As you enter or find yourself well into your retirement years, conversely, you simply cannot afford the risks of a 2008-like decline. In our opinion, a globally diversified portfolio with an appropriate allocation to bonds insures you against the one thing every investor fears: a market decline that alters the retirement you worked so hard to achieve.