Can You Better Manage Risk by Diversifying Your Investments?
No one who has worked hard to build a nest egg is especially comfortable with placing their money at risk. Yet, storing it under the mattress or in a cookie jar will actually decrease its buying power – and if these retirement assets are being socked away for 10, 20 or even 30 years from now, the impact of inflation and market sell offs when near retirement could be more destructive than you realize.
Over the long haul, investors need to be prepared to weather different economic cycles. It’s important to take advantage of bull runs whether in the stock market, real estate or other investment vehicles because these can grow your overall portfolio. Conversely, being prepared for the downside is equally important. Just since 1970, we have seen significant swings of fortune as the US has endured no fewer than seven recessions – including the Great Recession since the financial crisis – and seen a similar number of stock market crashes. That is a lot of volatility to handle as one approaches retirement.
One of the techniques that allow investors to mitigate investment risk is to create a diversified portfolio of assets. The basic idea is simple -- spread out your investments in order to hedge your hard earned savings. Instead of investing in a small number of investments or even a single asset, money is invested across many assets and in a variety of asset classes from stocks, mutual funds or ETFs, to bonds, real estate and precious metals like gold. This theoretically reduces risk across your portfolio. By spreading investments across a diversified portfolio, you avoid the “all eggs in one basket” problem. You also smooth out the bumps in the road while remaining invested for long term growth. Finally, diversification is not a one-time event. To properly maintain a diversified portfolio, investors need to reevaluate periodically and rebalance as necessary.
Diversifying with Gold and Silver
Let’s look at a popular diversification example that uses gold. Often, the price of gold has an inverse relationship to the U.S. dollar, typically when the value of the dollar drops, declining trust in the market often sends the cost of gold higher. This means that if all of your cash-backed stocks begin to drop, your gold shares may increase, saving you from detrimental losses. Historically, gold prices have maintained a strong inverse correlation to the strength of the U.S. economy. The price peaked in the 1980’s to more than $2,000 an ounce (inflation adjusted) when the US experienced high inflation.
In 2008, the housing market crash caused most stocks to plummet. Gold’s value fell along with other stocks, but within the year, gold was one of the only investments that managed to rebound shortly after and be up around 5% on the year. Those who held gold felt less pain due to the hedge. Gold has historically acted as a wealth preservation tool and could act as a volatility hedge to help guard investors through uncertain market conditions.
Financially Transitioning for Retirement
Financial planners recommend that investors approaching retirement should be more concerned with preservation of capital, not necessarily growth. Taking on riskier investment strategies can be devastating when there isn’t enough time to recuperate losses. The 2008 financial crises resulted in many seniors delaying their retirement or having to enter the work force again because they were to heavily weighted in the stock market.
A Strategic Approach to Portfolio Diversification
The ideal portfolio is developed with an investor’s unique goals in mind. When developing a plan, investors need to consider risk tolerance (or one’s tolerance for swings in the value of their portfolio), time horizon (how close to retirement), retirement needs, and of course your personal goals. Generally, advisors recommend that investors consider a portfolio that includes a mix of small to large-cap stocks, bonds, cash and a portion in alternative investments such as gold, real estate or other investments that have a lower correlation to the stock market.