The 7 Deadly Retirement Sins, Part 2
Improper Asset Allocation
Many people still equate investing to gambling. It is not uncommon for the average retiree to invest 100% of their assets in bonds during troubling market conditions or everything in stocks when the market seems to be moving higher. Your investments should never be all or nothing. What if your estimate about the future is wrong? The reason why the average person tends to dramatically underperform the market is because they become too emotionally involved in short-term market swings. Who can blame them? If I had 100% of my assets in stocks, I’d be nervous during a short but violent market correction as well.
The market goes through cycles, good and bad. The problem is that it is extremely difficult (and dare I say, impossible) to determine when these cycles will occur. By the time you can tell we are in a bear market…it is too late to sell.
Solution: The solution for this sin is also simple: it is again diversification. Diversification essentially means never owning enough of an asset class to make a killing in it or to be killed by it. By purchasing many different asset classes that have low correlations (technical speak for one may zig while the other zags) you can create a portfolio that will provide a higher return with less risk.
The asset classes that should make up your portfolio are stocks, bonds, cash, real estate, and commodities. Just what percentage of each of these asset classes should make up your portfolio varies greatly by investor and depends upon your age and risk tolerance. This is where a good Certified Financial Planner™ can help. They can provide you with an allocation that will keep your portfolio volatility to a minimum, but provide you a substantially higher return in the process.
The most common problem with the asset allocation of the average retiree is its emphasis on one asset class over another. Too many bonds and you are susceptible to inflation, too many stocks and you could become emotional when the market inevitably pulls back. It is important, especially in retirement to have the proper balance of all of these asset classes. This will allow you to take advantage of an investment opportunity when it is presented.
If you had a portfolio of all stocks and the market were to fall 30% at some point during your retirement (which is likely to happen), you would probably lose about 30% of that portfolios value. Since all of your portfolio is in stocks you would need to decide to sell your stocks as they fall or hang on and ride it out. Neither choice would be an ideal solution. However, even if you had a very simple diversification of 50% stocks and 50% bonds, this would give you options. Traditionally, as stocks fall, bonds increase in value (remember, one zigs while the other zags). As stocks prices decrease and become a more attractive investment, bond values will most likely increase. You will then have the ability to sell some of your bonds and use the proceeds to purchase more stocks at a lower price. Buy low and sell high…what a concept!