Author Topic: Diversify or not?  (Read 7871 times)

velocistar237

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Diversify or not?
« on: May 14, 2012, 10:25:22 AM »
Diane C recommended Ordinary People, Extraordinary Wealth by Ric Edelman, and I picked it up and skimmed it over the weekend. One of the chapters basically says, don't diversify, just invest in stocks.

This sounded completely wrong to me, especially coming out of the past few years, so I headed over to firecalc.com and punched some numbers in. It turns out, if you have a withdrawal rate lower than about 3.3%, 100% stocks is the best strategy, especially for long retirements. If you intend to draw down principal and retire for just a few years, it's good to have a diversified portfolio.

Is that right, or am I crazy? Does this change during the accumulation phase, or is it always the case?

arebelspy

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Re: Diversify or not?
« Reply #1 on: May 14, 2012, 11:51:05 AM »
I actually just read that this past weekend, and I agree with the general principal.

I'd say it's the way to go during the accumulation phase, but switch to at least some bonds in retirement.  A mix of 80/20 will provide nearly as much return, with a lot less volatility.

I'm mostly in real estate right now, due to the opportunity, but in a generic economy, I'd recommend being close to 100% stocks (index funds) in the accumulation phase.  Good rule of thumb, IMO, is to hold 120-your age in bonds.
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grantmeaname

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Re: Diversify or not?
« Reply #2 on: May 14, 2012, 12:13:41 PM »
120-your age in bonds.
120-your age in stocks, rest in bonds. Otherwise I'd own 100% bonds and increase my allocation to stocks as I got older!

James

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Re: Diversify or not?
« Reply #3 on: May 14, 2012, 12:36:21 PM »
The reason to have bonds is not just for security.  If you have a given percent in bonds and then religiously re-balance, say in May each year, you are able to automatically buy stocks high and sell low over time.  I have read that this provides increased (or at least matched) growth compared to an all stock portfolio, as well as added stability and security, all of which makes sense to me but that doesn't mean it's true.

grantmeaname

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Re: Diversify or not?
« Reply #4 on: May 14, 2012, 12:40:20 PM »
That was my impression as well. A Random Walk Down Wall Street has fantastic coverage of risk reduction by diversification... Malkiel, the author, suggests investing in large-cap, small-cap, and international stocks as well as bonds and he proves that doing so both increases the rewards and decreases the volatility relative to a single asset class. The last couple of chapters get very perscriptive about how to take on the ideal amount of risk for you and your life stage in exchange for the corresponding rewards.

Tyler

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Re: Diversify or not?
« Reply #5 on: May 14, 2012, 12:54:44 PM »
I can't imagine the misery of being 100% in stocks in 2008 when the market fell 40%. If I had just retired, I'd be freaking out.

IMHO, a good investment strategy doesn't just look OK on Firecalc - it also let's you sleep at night when something unexpected happens.  If you can't stick with a plan in bad times, it really isn't much of a plan. 

velocistar237

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Re: Diversify or not?
« Reply #6 on: May 14, 2012, 01:06:13 PM »
I'd say it's the way to go during the accumulation phase, but switch to at least some bonds in retirement.  A mix of 80/20 will provide nearly as much return, with a lot less volatility.

Assume you withdraw $30K annually over 60 years, starting at $1M. With 100% in stocks, "The lowest and highest portfolio balance throughout your retirement was $1,000,000 to $54,352,253, with an average of $19,263,792. (Note: values are in terms of the dollars as of the beginning of the retirement period for each cycle.)" With an 80/20 split, "The lowest and highest portfolio balance throughout your retirement was $1,000,000 to $32,301,622, with an average of $11,664,071."

Is reducing volatility worth it when it reduces your average final balance from $19M to $12M, especially when your portfolio is never in danger?

What about the Permanent Portfolio? Would it be any better than a stock/bond allocation?

The reason to have bonds is not just for security.  If you have a given percent in bonds and then religiously re-balance, say in May each year, you are able to automatically buy stocks high and sell low over time.  I have read that this provides increased (or at least matched) growth compared to an all stock portfolio, as well as added stability and security, all of which makes sense to me but that doesn't mean it's true.

That's what I was thinking, but I just now checked the Firecalc FAQ:

"Does the model assume annual rebalancing?
Yes, it assumes you maintain the same ratio between equities and fixed income investments by rebalancing at the time of each annual withdrawal."

A Random Walk Down Wall Street has fantastic coverage of risk reduction by diversification...

I still need to read that book. I only got to the tulip part, and then I had to return it to the library.

My hypothesis: most analyses involve shorter retirements and the withdrawal of principal. If you have a low enough withdrawal rate, then it's best to be in 100% stocks.

How can I test that more thoroughly? I want to know the answer, because it's very practical. I suppose I can start with Malkiel's book.

IMHO, a good investment strategy doesn't just look OK on Firecalc - it also let's you sleep at night when something unexpected happens.  If you can't stick with a plan in bad times, it really isn't much of a plan. 

True, though anything that would have helped you sleep through 2008 would probably give you anemic returns over the long run.

arebelspy

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Re: Diversify or not?
« Reply #7 on: May 14, 2012, 02:10:36 PM »
120-your age in bonds.
120-your age in stocks, rest in bonds. Otherwise I'd own 100% bonds and increase my allocation to stocks as I got older!

*.  I say that backwards EVERY time.  Thanks for correcting me.

At least I'm not the only one to state things backwards!  I don't feel so lonely.

If you have a given percent in bonds and then religiously re-balance, say in May each year, you are able to automatically buy stocks high and sell low over time.

Flip that.  ;)
« Last Edit: May 14, 2012, 02:12:55 PM by arebelspy »
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Tyler

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Re: Diversify or not?
« Reply #8 on: May 14, 2012, 03:21:01 PM »
"True, though anything that would have helped you sleep through 2008 would probably give you anemic returns over the long run."

The Harry Browne Permanent Portfolio has only 25% stock. From 1972-2008, the PP had a CAGR o 9.7% compared to 9.3% for the total stock market. And it did so with much less volatility - it only lost money twice over that timeframe, and MADE 2% in 2008.  ;)

There's more than one way to skin a portfolio.

velocistar237

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Re: Diversify or not?
« Reply #9 on: May 15, 2012, 06:16:04 AM »
In the "Your Portfolio" tab in FIREcalc, I tried the Total Market with 0.18% expenses and got an average $7M after 50 years, but with the "Mixed Portfolio" with 0.5% expenses and default allocations, I got $20M. I suppose there is something to diversification, but it takes more than a stock/bond "lazy" portfolio to benefit much from it. The Permanent Portfolio looks like a good choice if you execute it well.

tooqk4u22

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Re: Diversify or not?
« Reply #10 on: May 15, 2012, 08:35:35 AM »
"True, though anything that would have helped you sleep through 2008 would probably give you anemic returns over the long run."

The Harry Browne Permanent Portfolio has only 25% stock. From 1972-2008, the PP had a CAGR o 9.7% compared to 9.3% for the total stock market. And it did so with much less volatility - it only lost money twice over that timeframe, and MADE 2% in 2008.  ;)

There's more than one way to skin a portfolio.

The Permanent Portfolio will not work going forward like it has over the last 30 years because much of it was driven buy the never ending bull market in US Treasuries because of declining interest rates.  The interest rate on the 10 year UST in 1981 was about 16% and now it is 1.78% - that translates into a return on principle of about 7.3%.  In 2008, 10-Year UST went from 3.5% at the beginning of the year to 2.7% translating to 28% return - gold also spiked during this period - both of these were fear driven.    Its over because rates can't really go below where they are at unless of course our economy craters and we go to zero (which adjusted for inflation current rates are at or below zero).  Best case is that rates stay where they are giving you a paltry return but if they turn it won't be pretty, gold will get whacked as well.  Once the economy starts humming again capital will flow back to more productive investment classes, rates will rise, the dollar will strengthen and gold will fall.  When that happens that will be a better time to go with the permanent portfolio. 

James

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Re: Diversify or not?
« Reply #11 on: May 15, 2012, 08:48:30 AM »

If you have a given percent in bonds and then religiously re-balance, say in May each year, you are able to automatically buy stocks high and sell low over time.

Flip that.  ;)

Thanks, glad to be in good company...  :D

Tyler

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Re: Diversify or not?
« Reply #12 on: May 15, 2012, 09:58:30 AM »
The Permanent Portfolio will not work going forward like it has over the last 30 years because much of it was driven buy the never ending bull market in US Treasuries because of declining interest rates.  The interest rate on the 10 year UST in 1981 was about 16% and now it is 1.78% - that translates into a return on principle of about 7.3%.  In 2008, 10-Year UST went from 3.5% at the beginning of the year to 2.7% translating to 28% return - gold also spiked during this period - both of these were fear driven.    Its over because rates can't really go below where they are at unless of course our economy craters and we go to zero (which adjusted for inflation current rates are at or below zero).  Best case is that rates stay where they are giving you a paltry return but if they turn it won't be pretty, gold will get whacked as well.  Once the economy starts humming again capital will flow back to more productive investment classes, rates will rise, the dollar will strengthen and gold will fall.  When that happens that will be a better time to go with the permanent portfolio.

All good points.  I was just showing that for 40 years now there has been a low-stock investment option that has matched the stock market with much lower volatility under a variety of economic conditions.  Whether or not that will continue -- who knows.  We also don't know when the prolonged 10-year period of no real returns on stocks will end, either.

To each his own.  As I said, investment strategy is really about your personal comfort.  However, whether or not the PP is for you I still wouldn't recommend putting 100% of your money in any single asset.  Even a little bit of diversity will help minimize risk.

tooqk4u22

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Re: Diversify or not?
« Reply #13 on: May 15, 2012, 10:52:08 AM »
To each his own.  As I said, investment strategy is really about your personal comfort.  However, whether or not the PP is for you I still wouldn't recommend putting 100% of your money in any single asset.  Even a little bit of diversity will help minimize risk.
[/quote]

Wasn't bashing diversification, just don't think PP is the way to go right now but some variation/adjustment to the theory of it could be ok.  To have 25% in low yielding bonds (with potentially high downside risk) and 25% in gold (an asset that is really only used for jewelry and reserves) doesn't make sense to me - althought he PP fund has expanded beyond its original model into some real estate, silver, whatever so maybe it will be ok. 

Regardless you are spot on with not putting it all in one basket and with diversification you can get to the same endpoint (maybe leave a few dollars on the table) but with a lot less volatility) - but the mix is highly subjective.

% Bonds (Total)
% US Equities
% International (Europe/Emerging Markets)
% REITS/Commodities



JoeK

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Re: Diversify or not?
« Reply #14 on: May 15, 2012, 10:59:58 AM »
I can't imagine the misery of being 100% in stocks in 2008 when the market fell 40%. If I had just retired, I'd be freaking out.

IMHO, a good investment strategy doesn't just look OK on Firecalc - it also let's you sleep at night when something unexpected happens.  If you can't stick with a plan in bad times, it really isn't much of a plan.

If the stocks that you invested in were stable dividend paying stocks, with a long history of raising dividends every year, then 2008's market crash wouldn't have mattered at all, assuming you were living off the dividend income.

If you invest in companies like KO, JNJ, PG, etc., with a goal of living off dividends then there is very little risk involved.  Market price is irrelevant if you don't ever sell any shares.

If I had just retired in 2008, I would be thrilled because any excess dividend income could be used to pick up more shares at extremely low prices (and high yields).

tooqk4u22

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Re: Diversify or not?
« Reply #15 on: May 15, 2012, 11:23:32 AM »
If the stocks that you invested in were stable dividend paying stocks, with a long history of raising dividends every year, then 2008's market crash wouldn't have mattered at all, assuming you were living off the dividend income.

If you invest in companies like KO, JNJ, PG, etc., with a goal of living off dividends then there is very little risk involved.  Market price is irrelevant if you don't ever sell any shares.

If I had just retired in 2008, I would be thrilled because any excess dividend income could be used to pick up more shares at extremely low prices (and high yields).
[/quote]

This is partially correct if you had the right stocks but almost all of the financials, the REITs, GE, etc. cut their dividends dramatically if you were overweight in these your income would have been crushed. 

If you were in the S&P 500 dividends (not yield) went down by 24%, which may not be devestating but you would have felt an impact and maybe even would have sold some shares to offset the drop, who knows.  The S&P 500 dividends have recovered most of it and are now about 6% off the peak dividends coupled with the low inflation in real terms that means your income would be off 10-12% from the highs. 


JoeK

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Re: Diversify or not?
« Reply #16 on: May 15, 2012, 11:37:43 AM »
This is partially correct if you had the right stocks but almost all of the financials, the REITs, GE, etc. cut their dividends dramatically if you were overweight in these your income would have been crushed. 

If you were in the S&P 500 dividends (not yield) went down by 24%, which may not be devestating but you would have felt an impact and maybe even would have sold some shares to offset the drop, who knows.  The S&P 500 dividends have recovered most of it and are now about 6% off the peak dividends coupled with the low inflation in real terms that means your income would be off 10-12% from the highs.

You can be invested 100% in stocks and still be diversified enough to be able to withstand those types of things.  If you were invested 100% in dividend aristocrats in 2008, and, say, 10% or 15% of those were financials that cut their dividends, the raises in dividends from the rest of those companies would be enough to offset most of the drop.

Tyler

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Re: Diversify or not?
« Reply #17 on: May 15, 2012, 11:57:23 AM »
I also like to think about credit risk.  For example, GM was a large established company that paid a fat 6.3% dividend in 2005.  Then it eliminated its dividend in 2008 before filing for chapter 11 and wiping out its shareholders.

I can see the appeal of dividend investing, but be sure to diversify like crazy if you do that.  The company that looks perfectly safe today may not be there tomorrow when you need that income the most. 

JoeK

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Re: Diversify or not?
« Reply #18 on: May 15, 2012, 12:31:14 PM »
I also like to think about credit risk.  For example, GM was a large established company that paid a fat 6.3% dividend in 2005.  Then it eliminated its dividend in 2008 before filing for chapter 11 and wiping out its shareholders.

I can see the appeal of dividend investing, but be sure to diversify like crazy if you do that.  The company that looks perfectly safe today may not be there tomorrow when you need that income the most.

If you invested in, say, 20 different companies with long histories of growing dividends, then a company going bankrupt would only destroy 5% of your overall wealth (and income).  If you are earning $30,000 per year in dividends then you'd only lose $1500 from Company X stopping their dividend payments.  And many of the other companies would continue raising their dividend, so the hit to your annual income would be minimal. 

2008 was the worst recession in the US since the 1930s, and most of the dividend aristocrats (outside of financials) continued raising their dividends during that time.  Will we see another Great Depression?  Maybe...but I expect KO, MCD, JNJ, PG, WMT, and so on, to continue raising dividends (or at least keep them steady) even if we do, as they have in the past during difficult economic times.