Diversification is not a fail safe plan. There is no such thing. With the possibility of return comes risk. So no matter how you invest you are going to come up against some risk, yes even govt bonds, even though they are said to have no risk, technically they do have some risk.
Diversification does work the way it is designed to work. Even though I believe there is such a thing as over-diversification, diversification itself is a good idea for the average investor.
I have read a few articles that speak about the 2008 collapse and how financial advisers need to come up with a different strategy because diversification doesn’t work. This is just simply not true.
There are two types of risk out there, idiosyncratic risk and systematic risk. Idiosyncratic risk is risk that affects only a certain area of the market. Systematic risk affects the whole entire market. The collapse in 2008 is considered Systematic risk and diversification by definition is designed only to protect against idiosyncratic risk (which is why it’s also called diversifiable risk). For example if I diversified by buying 1000 shares of GM stock and BOA before the collapse I would have nothing left of the 1000 I had in GM stock. However I would still have my 1000 in BOA. You’re saying that BOA is worth a lot less than it was 2 years ago. Well this is true because the systematic risk brought the whole market down. However if I didn’t diversify and bought a 1000 in GM and 1000 in Chrysler (both in the auto market) I would have nothing. So diversification works but it will not protect you against a total economy collapse.
Saying that diversification failed in 2008 would be like building a sand bag wall around your house and then complaining because it didn’t stop water from leaking through your foundation. It’s just simply not meant to protect against that.

Good choice if you don’t know if you son/daughter are going to go to college.

How about Total NET WORTH diversification which includes debt, assets outside of the Stock Markets along with 100% safe Cash, real estate etc. When ALL of your assets are considered and liabilities deducted from Debt you have a complete picture of where you are and you MAY see you are totally reliant on one of several classes of assets or Stock Market investments.

If your Net Worth isn’t growing and you have $$$ in the Stock Market its a belief that you are doing the right things? Wrong! My point is that all of the debt reduction schemes one can come up with is only one small part of total diversification. The word itself can mean a much wider scope than simply Stocks, Bonds, Cash.

You will NOT find this Net Worth approach in most Mutual fund or investment guidance because they want ALL of your money.

Example is Madoff investors who sold all assets and put all money in his investments and lived off the income! Totally naive people and you gotta WORK at this stuff to assure that no single sector or asset class is succeptable to a major loss or downturn.

Also, downside limited investments with 50-60+% of an upside market could leave one with 20-30% losses versus 50-60% losses. Calculate the “get back to even” on these and you can see that limiting losses is an important strategy. 5yr recovery versus 10+ years is important for people to know about.

There is much more involved with this approach but you will NOT see most investment companies or mutual fund companies using a total net worth approach.

No matter what you pick for a retirement #’s it makes little difference if you arrive there and have what has just happened 20 years from today!

That thought is way too narrowly discussed and simply starting saving early is not the answer. Start early and recognize you MUST be totally diversified through out your life. Debt is one HUGE influence on your success for sure but ending with everything in the Stock Markets only puts your money where somone else profits daily, weekly monthly with continual fee erosion, even when you are losing money. Even inflation erosion on cash in 2008 was about 40% less loss than being in the Market.

I was -34% in the market in 2008, -30% housing equity and with cash building for the last 9 years end up with a total Net Worth related loss of -18%. Market recovery is 5.4 years at 7.5% returns versus 10.3 years for others. Housing recovery is not even predictable……… Stock Market assets are only 26% of total net worth.

Zero debt.

66yrs old, still can retire tomorrow morning if I want to. Could NOT have achieved this without the net worth approach. 10+ Years ago did an ongoing analysis and found 50%+ of net worth was in my HOME. Rest was in Markets at that time. Huge appreciation of real estate skewed the numbers.

Calculated that I had enough “deferred investments” that I will pay taxes on in retirement This is another aspect for the 20 somethings to be told about! You can have too much in deferred 401K and IRAs at some point.

No one is gonna tell you this from Mutual fund company…………..

Ken Swift

My take is $750K (inflation eaten or not) is better than nothing, and $30K a year is better than $10K, and goals can grow or change as your own circumstances do. You don’t have to save at the max now. Save what you can and work to build it. I started with 5% of my salary for retirement, then inched it up over the years to 15% now. Will it be enough? I don’t know, but it’ll be a hell of a lot better than if I didn’t save anything or waited until I thought I could start with the 15%. I also realized there was no way I was going to fully fund my children’s college (and a mortgage, and car payments, and retirement) but I wanted to save something. So when each was born I started with $20 a paycheck and added $5 every raise or COL increase. My oldest starts state college in the fall and she’ll be taking out loans. But we are better off for what I managed to save, even it only pays for about half.

The main point of the above article is to start saving and don’t fall into paralysis of analysis in looking at all the options. My point to add is save something, anything, and try to regularly grow that amount over the years as you can because all the estimates, projections and advise mean squat if you don’t have something to work with in the end.

How did we go from the premise “Don’t Over Think Your Investments” to a rant about whether $750k is enough or what impact inflation will have or whether social security will be around or how much someone needs to live on?

I think Trent makes a sound argument and comments like these further this belief. None of us know what tomorrow will bring, neither do the experts nor the clowns on wall street that tell us they do.

Far too many people get wrapped up, and subsequently confused, by the messages sent by the financial industry (all with the aim of selling a product and taking your money) and it really does not need to be that way. Keep it simple is a great strategy.

And as they always say, past performance is no guarantee of future results… say an investor researches funds with a good 5-10 year track record and goes with one of them; what happens if the manager who led that fund retires in two years? I used Magellan to help pay for college back when Peter Lynch was the manager, and I’m glad he hadn’t retired sooner! (Magellan today isn’t nearly the fund it was under Lynch.)

I’ll shoot for average and happily take the above average results.

Everything else (bond funds, REITs, stocks, foreign currency, oil, gold, etc.) got clobbered in 2008 as highly leveraged concerns had to sell their assets to raise cash in order to pay their bills.

Thanks for the clarification. The point I was trying to make was that $30,000 per year (which is like $12,000 in today’s dollars) plus whatever Social Security you get is not very much to live on. If you only had to withdraw $30k off of $750k then you wouldn’t run out of money–your standard of living would just be really low.

Anyway, as poor investors like Trent and J.D. Roth move their money into indexes and encourage other poor investors to do the same, the average skill in the market will rise and active investing will become more difficult. The new group of poor investors might leave for index funds as well, creating an interesting cycle that makes active investing very difficult.

On the other hand, indexes are predictable and it’s easy to make money trading shares before the prospectuses of index funds force them to trade. This especially happens when a company becomes large enough to join the S&P 500. Someday half the money in the market might be in indexes, and if they have to add or sell a security, trade in that security will be so imbalanced (as not enough active traders exist to take the opposite bet) that returns will greatly suffer.

Thanks for the clarification. The point I was trying to make was that $30,000 per year (which is like $12,000 in today’s dollars) plus whatever Social Security you get is not very much to live on. If you only had to withdraw $30k off of $750k then you wouldn’t run out of money–your standard of living would just be really low.

Trent,

No disrespect intended, but you are trotting out the old ‘rules of thumb.’ Those are simply not good enough. Just look at the people you know to see that’s the truth. Fresh ideas are needed.

The people who take responsibility for managing money – are out to protect themselves from lawsuits. They are not out to give you winning advice. That’s why they advise diversification, asset allocation, buy stocks in bull and bear markets etc. With those ‘prudent’ suggestions, they cannot be sued successfully.

That’s the truth as to why those are the ‘rules,’ But if you think for yourself – as you seem to be doing in all areas of PF, then you will discover that the old-fashioned, incorrect, unhelpful advice that everyone offers, is not good advice after all. It’s just a cover-up so the ‘professionals’ can take your money with fees and commissions and protect themselves from any responsibility.

Diversification does not work. it’s a myth. What it does do – is it helps most of the time. But it would not ave helped last year. And most is not good enough.

What works is a cheap insurance policy. And that’s where conservative option strategies come into play. Specifically collars, but there are other choices.

http://blog.mdwoptions.com/options_for_rookies/2008/07/example-of-a-co.html

“The market” historically has represented the best financial wisdom, such as it was, of the entire investor class. Managed mutual funds ended up with a large stake, narrowing the base from which this “wisdom” is coming, and with index funds, the base will be narrowed even more.

Buying an index fund is the same as delegating your thinking to whomever else is still doing any thinking. Everyone who does that is withholding his or her own little bit of special perspective or knowledge, making the market less a reflection of the collective wisdom of all investors, and more a reflction of the collective wisdom of large institutional fund managers. That’s bound to change the market as a whole, and therefore is likely to mean that future returns will less closely track historical returns – either for better or for worse.

Please understand I’m not saying there’s anything wrong with choosing index funds, only that as more people do that, “the market” will be a different creature than it was before, and presumably so will its overall rate of return.

$750,000 (in today’s dollars, i.e., inflation-adjusted) of retirement savings at age 60 is far above the current average retirement savings and not an unreasonable goal. Especially combined with a paid-off house and modest spending habits, one could live comfortably on that in all but a few parts of the country.

However, to get to the equivalent of $750,000 in today’s dollars on $5,000 a year savings over 35 years requires monthly compounding based on an annual rate of return of 7% OVER INFLATION, not just an “average” rate of return of 7% per annum. A 35-year compounding rate of return of 7% per annum over inflation is not very likely.

If you haven’t already done one, a column on the difference between “average annual rate of return” and “compounded annual rate of return” and the effects of that difference on a portfolio would be very informative for your readers.

The only “risk-free” inflation-adjusted investments out there are the inflation-protected Treasuries (TIPS), which I think on current issues are yielding less than 2%. Any return above that represents an extra premium you are being paid for the risk that you will lose some or all of your principal. And losses to your principal can dramatically lower your COMPOUNDED rate of return, even if your AVERAGE return recovers.

So, although for different reasons, I would urge a 25-year old to try to do better than $5,000 a year, if at all possible. But any amount at all is better than nothing.

Of course this assumes that your rate does not drop much below 7% for any length of time — which is a problem with almost ALL retirement advice. It turns out that when you retire the STABILITY of your return is *much* more important than the SIZE of your return. I for one would much rather have a guaranteed rate of 5% than an average of 7% that fluctuates between 3% and 10%. Note: This only applies in retirement situations and when you are getting close to retirement.

This is, of course, why people speak of “diversification,” though I feel this term is actually misused. What you are trying to do, as you approach retirement is not to diversify, but to reduce the amount of variation in your returns. For instance, if you had enough money, then the best retirement investment would be in 30 year government bonds. So, the term “diversification” is misleading (since you would LIKE to have everything in bonds, in reality). Rather, perhaps “reducing volatility” is a better descriptor.

Saving early is definitely something people should do. But I feel like personal finance has overrated “compound interest” for a long time to make it seem like if you start early you don’t have to save very much. If you save like that and then there’s a crash near when you want to retire, you’ll be nowhere near where you need to be. Vanguard’s 2010 Target-Date retirement fund lost 20% last year…

Agreed, $750,000 seems a little low. But the point remains the same (just that $5,000 either needs to go up, or the return does… and I think its safer to assume the amount invested should be the first to go up!).