Building wealth and security to live a successfully in retirement means accumulating assets while you work that can produce income for you when you retire. But doing so is not easy. As an investor you are bombarded by “advice” from all corners. Much of it is generic and most of it is offered by people who have an invested interest in promoting one investment option over another.
As a general comment, all investments offered by major financial institutions can be reasonable. Determining if it is reasonable or appropriate for you is a different matter. Do the benefits and costs match what you are trying to accomplish?
That is a decision you must make based on your needs, both analytical and emotional.
Since there is no simple answer, let’s look at why diversification is so important to your financial security
Volatility is scary
The stock market has historically returned more than bonds or other interest baring accounts over time. Since 19 stocks have returned about 7% while high quality corporate bonds about 4%. One reason stocks have a historically higher rate of return is that the price of a stock is subject to significant volatility in the short run.
In the short run, markets go up and down, and often quite violently. We all remember 2007 to 2009 when the stock market fell 55%. Of course, today the market is double where it was in 2007
This volatility creates opportunities to buy low and sell high. For speculators and investors to make money and exposes them to risks of making the wrong decision
If the professionals can’t seem to get it right consistently, how will you?
Diversification reduces volatility
The stock market is the collection of lots of stocks. The bond market … lots of bonds, and there are many other specialized investments as well from private companies, to insurance contracts, annuities, bank certificates of deposits and every more complex financial products.
One thing most investment professional know is that all investments don’t act the same. Some will go up when others go down. That’s why having a well-diversified portfolio is so important. The more you are concentrated in one asset or asset class, the more your overall wealth will go up and down with that one asset. It’s great when your chosen asset or stock is doing better than others … but not so great when it isn’t.
Emotions are expensive
The reason most people are poor investors is they let their emotions get in the way. When markets go down, they fear the end of the world and sell (when they should be buying) and when their investments are doing well, they assume that will continue forever (rather than sell).
Buying low and selling high is what everyone wants to do but buying when everyone is selling is so hard to do, as is selling when you have significant gains.
Matching investments to time horizon is the key to success.
Being exposed to market volatility is not bad if you have matched your portfolio to the time period you are investing for. When your 30, do you care if your investment portfolio goes down 25% in one year? Perhaps not if that is assets you’ve invested to fund your retirement in 30 years’ time. If you are 65 and are looking to move into a comfortable retirement, then a 25% decrease would be very scary.
As we indicated above, being scared leads to selling at the wrong time and not buying in again. Thus, taking big losses and missing out on big gains.