Diversity is still king for portfolio protection
Safety and security for retired investors have been overrated, and we need to think differently about these concepts and about diversification.
Safety and security for retired investors have been overrated, and we need to think differently about these concepts and about diversification.
Over the last year, we saw highly rated bonds collapse in value, money market funds come under pressure, yield enhanced funds tank, auction rate securities hammered, insurance companies (and the guarantees they made) take a dive, and mortgage-backed securities get crushed.
In one form or another, all of these securities were designed to provide a fixed-income-like return, and a stable principal value. Yet in the crisis, the principal value often sank and the income feature sometimes vanished.
How can we deal with this new reality of risk?
Actually, quite simply by using the most unique tool in finance, which is diversification.
While advisers will differ on how much of a retirement portfolio to dedicate to fixed income, it’s fair to say that whatever money they do allocate, they want it to hold up in a storm.
Fixed income securities are an important part of managing risk in retirement income portfolios. If the equities decline, the fixed income needs to be there to backstop the portfolio and provide cash flow. If the fixed income assets don’t do their job, the client’s retirement security is in real jeopardy.
While diversification has gotten a lot of criticism lately, if you look at the facts as they relate to fixed income assets, diversification worked. If there is one thing to take away from this recent crisis, it is that more diversification can create safer fixed income portfolios.
Just take a look at the Barclays US Aggregate Bond Index for Barclays Global Advisors in San Francisco. Given the massive problems in the credit markets in 2008, you would have thought the bond market would have been down for the year.
Yet, the Barclays US Aggregate Bond Index was positive by about 5% in 2008. Why, because it is a highly diversified mix of Treasury, agency and investment grade corporate bonds. While a few bonds in the index did collapse, thousands of others, most notably Treasuries, did just fine. We of course know there are no guarantees with respect to future returns, but last year was a pretty good test, and diversification did work.
In general, if investors experienced significant problems with their fixed income investments it was primarily because they were not diversified enough. Since investors believed they owned safe fixed income securities, many concentrated their “safe” money within a few types of securities. Given what investors understood about risk prior to this credit crisis, that appeared reasonable.
But now we know more. This crisis has exposed our limitations on assessing specific risk in modern financial markets. To compensate for those shortcomings, we should consider more diversification. And diversification is pretty easy to accomplish these days.
So if you’re going to own bonds, why not own hundreds or even thousands of high quality bonds through various index tracking exchange traded funds. This certainly doesn’t mean you should abandon individual bonds. There are plenty of investment and tax advantages to owning individual fixed income securities. But you may want to consider enhancing your high quality holdings with more diversification.
If you want to use structured products, why not spread them around to multiple firms. If you concentrate them with one firm, and that firm gets into trouble, you won’t have too many options.
If you want to buy an immediate annuity for lifetime income, think about buying multiple annuities from different insurance companies. Once the insurance company has the money, you can’t get it back. So if your guaranteed income stream is dependent on the survival of one firm, it could get pretty uncomfortable.
And don’t forget about a healthy dose of Treasuries or other US guaranteed debt instruments. In the next crisis (and there will be a next crisis), they will probably come in pretty handy.
It’s important to learn something from each financial meltdown. In the tech unwinding, we learned that valuations really do matter. In this credit crisis, we learned that there are limitations to financial engineering. Our ability to assess and manage risk is not quite as good as we thought. But, we still have the ability to use simple diversification, which can help create more secure retirement portfolios for investors.
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