Diversified Portfolio is Still the Long-Term Favorite

There’s a lot of soul-searching among advisers these days, when financial markets all over the world seem to be tanking simultaneously. Still, past experience has shown that pulling an investment portfolio entirely out of stocks after a downturn is a bad idea. The problem is that no one can say for certain when stock markets will begin to go up.  Mind you, eventually some stock timer somewhere will announce that it’s time to get back into stocks, and lo, the stock market will climb, as if by magic.  But with thousands of professional stock timers out there making predictions, someone will have to be right eventually.  It’s very difficult to tell the difference between prescience and dumb luck.

If you need to spend from the contents of your portfolio, having to sell stock-related holdings right now would be pretty painful.  That’s why it’s generally a good idea, as you come within 10-15 years of the day when you start spending your portfolio, to have some of your money in bonds or cash.  This is true even for extremely aggressive investors.

For investors who are in the conservative to moderately aggressive range, it’s even more important to have a portfolio diversified between risky and less-risky asset classes. Why? Because if you can’t bear having your portfolio value drop by 35% from its peak, the way the US market has, you need to have part of your portfolio in less volatile assets. Then, if your risky assets experience a drop such as we’ve seen this year, you won’t be tempted to panic and “sell low.”

Investors who are now retired but who had a good chunk of their portfolios in cash and/or bonds may be unhappy, but they don’t have to panic. If they have four or five years worth of required withdrawals in low-risk assets, they don’t need to sell the assets that have tanked. They have time to wait for things to calm down and, in all likelihood, for the equity portion of their portfolio to go up.

As one colleague pointed out, one “bright side” of markets in the last few weeks is that everyone has learned that owning individual stocks is much, much riskier than owning diversified mutual funds. The Dow Jones has dropped 35%, and some foreign markets have dropped farther, but the stock prices of a number of companies that not so long ago were thought of as “safe” have gone through the floor: AIG (down 96% from a year ago), GE (down 50%), and Lehman Brothers (down almost 100%, since the company is bankrupt) were once considered to be solid, reliable stocks, but each has experienced specific events that have caused its stock price to collapse.

Investors who are close to retirement are not necessarily stuck if they’re caught right now with too much of their money in stocks. One option is to keep working, and salt away money now in cash and other low-risk assets.  Another option, for those who can’t work, is to find ways to cut back on spending.

Better yet, if you can, do both.  No one can say for certain how long the recession will last, but it seems reasonable to expect the economy to recover within the next one to three years. When that happens, stocks, commodities, and other risky assets should also recover in price.

About the author

Thomas Fisher, CFP®
Thomas Fisher, CFP®

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