Diversification means I have low risk, right?
Diversification has become like pixie dust in the financial world. People hear that word and think everything is good because they are diversified, but that is not always the case.
The thought is if your diversified than you will have a lower risk because you are not putting all your eggs in one basket as the saying goes, however, while diversification and asset allocation are important it does not guarantee lower risk.
Sometimes you can have a highly diversified portfolio among different stocks or funds, but they are all highly correlated meaning they go up and down about the same. It would be like putting all your eggs in different baskets but then putting all the baskets in the back of the same pick-up truck. When that truck hits a bump, all the baskets fly, and all the eggs break. That is highly correlated.
The rule of 100 has been used as a good starting point in determining your diversification between stock funds and bond funds. You simply take your age and subtract it from 100; the answer is the most you should have at risk (example 100 – 60 = 40% of at-risk investments). Now, remember that is a guideline, some will have a little more at risk and be a little more aggressive, some will have less at risk and invest everything more conservatively.
Bonds have typically been considered a good place for the 60% in the above example and many firms still use bonds and bond funds for that portion. However, with the stock market at an all-time high and rising interest rates (when interest rates rise, bond values fall), we could be poised to see a bear bond market coming, maybe even at the same time as a bear stock market.
The average 60/40 portfolio, when stress-tested has an average drawdown or loss potential of 30% or more. Is that lower risk?
So, while diversification is good, in and of itself does not mean you are low risk. How you are diversified, among what asset classes and how that is managed determines your risk.
If you want to know what your risk is, have a risk assessment done on your portfolio. This should be run by third-party investment research and analytics firm such as Morning Star. This report is more than a snapshot of your portfolio, it analysis the funds in your portfolio and can give you a probability of upside and downside return potential. Everyone, especially those in or nearing retirement should have an updated risk assessment done on a regular basis.
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