Diversification is a Must


Question:  Last week you responded to a writer about bonds and bond funds.  What I thought was particularly interesting was your example of an investment plan for a retiree generating $50,000 per year starting with $1.2 million in an IRA account. You suggested writing an investment policy statement (IPS) taking into account various risk factors and investment objectives and then, based on the IPS, allocating funds to various investment options including bond funds, equity assets, and others.   Wouldn’t it be simpler to just invest in bonds or bond funds paying 5% or more?  The retiree would get the $50,000 in annual income he or she is looking for and hopefully keep up with inflation.   

Answer:  A strategy that involves placing all your assets into one asset class, such as bonds, is a common mistake that amateur investors make.  If you have so much money that you are certain you will never have to worry about having enough income and principal to support your lifestyle, regardless of how high inflation gets and how long you live, it might work.  Although, a wise investor would not limit herself to your suggestion of just corporate bonds.  Even if you had that much money, why not make the best use of it and let it grow?

We have learned a lot about the art and the science of investing over the past 40 years.  Why not make use of that wisdom?

There are three primary reasons why I respectfully disagree with your suggestion: (1) Inflation, (2) Lack of diversification, and (3) Lack of growth potential. 

1) Inflation

Let’s say you were able to buy a diversified, laddered portfolio of corporate bonds with an average yield of 5%.  What happens if, in the next few years, inflation surges to 5% or higher?  Your laddering strategy will allow you to purchase new bonds with higher yields, but not quickly enough to keep up with inflation.  Depending on how high inflation goes, you will be doomed to fall behind and never catch up.  Your “real return,” the rate of return after inflation, will be negative.  You may never again have the opportunity to generate that $50,000 per year of income in today’s dollars that you had planned on having for the rest of your life.

2) Lack of Diversification

If you don’t diversify among asset classes, you are taking the risk that your chosen asset class may under perform other asset classes for a long period of time.  Single asset classes can have very long periods of underperformance.  Here is a good example:

In 1935, while the nation was recovering from the depression, investors sought safety.  Many bought government bonds.  But from 1935 until 1980, investors holding intermediate term government bonds over that 45 year period ended up, after inflation, with less money then they started with, even without taking any withdrawals!

3) Lack of Growth Potential

Growth is good.  Ideally, your principal will grow while it is generating enough income to cover living expenses.  A healthy portfolio will generate a total return that provides enough of an increase in value over time to allow for increased annual withdrawals to keep up with inflation.  A portfolio of corporate bonds that generates just enough to live on won’t measure up to this.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to ken@montereypw.com.