Why Diversifying your Retirement Portfolio is Important
When building a retirement portfolio, it can be tempting to focus solely on one type of investment. Diversifying your retirement portfolio is recommended in order to ensure you maximize profits and reduce risk. Here are a few reasons why you should strongly consider diversifying your own retirement portfolio.
Maximizing the Sequence of Returns
An important element of any retirement portfolio is the “sequence of returns”, which is the order in which returns occur. A portfolio based on a high number of low returns just shortly after a person retires will not allow for longevity. Wade Pfau, a professor of retirement income at The American College, advises people to “hold fixed-income assets to maturity or use risk-pooling assets such as annuities” when building a portfolio to reduce the sequence of return risk.
Avoiding the “Age in Bonds” Approach
Another approach to building a retirement portfolio is known as “age in bonds.” This concept requires people to build a portfolio containing a bond allocation that is equal to their current age. While this does reduce one’s risk, it does not allow for the growth that is required in order to build a successful retirement portfolio. A retirement portfolio should minimize risk while at the same time providing a reasonable amount of growth, something that cannot be achieved when investing in a single product such as bonds.
Accounting for Changes in Risk Tolerance
Everyone has a different “risk tolerance”, or comfort level with taking risks. It’s not unusual for your risk tolerance to change over time. You may feel very comfortable taking risks during your younger years, but as you approach middle age and beyond, the idea of taking risks may suddenly make you uncomfortable. Your attitude may also change after you have experienced a significant loss, or even if you find yourself unhappy with the amount of money your portfolio has earned. Diversification will help you adjust to these changes in attitude as time goes on much better than putting all your eggs in one basket will.
Adjusting for your Personal “Time Horizon”
Your time horizon is the number of years until you are expected to need the money. As you grow older, your time horizon will naturally change because there are fewer years until retirement. You may find that as your time horizon shrinks, so does your risk tolerance, in which case you may want to reallocate some assets. Investment experts recommend moving at least part of your portfolio into low-risk, stable investments that are capable of generating a small amount of income. This could require drastic changes to your portfolio unless it is already diversified somewhat.
Investing in a single commodity is not recommended for a number of reasons. Only when your retirement portfolio is as diverse as possible can you effectively mitigate risks while at the same time ensuring you have adequate funds available when needed. A diverse portfolio will also account for your changing needs both now and in the future.