Yahoo Finance Why Diversifying Your 401(k) Is Crucial
Diversifying one's investment portfolio via different asset classes has long been the holy grail of retirement investors, ever since a landmark 1952 paper on long-term investing by Nobel Prize-winning economist Harry Markowitz, who was then just a student at the University of Chicago.
In the ensuing 60-plus years, money managers have taken the theory as gospel. And with the rise of the defined contribution plan -- notably the 401(k) -- investment specialists have beaten the drum for diversification, and most investors have taken their advice.
With a new year beckoning and strong talk of a volatile stock market in 2017, it's a good time to revisit the diversification issue. Does Markowitz's theory still hold up to strong scrutiny? Is diversification still a strong platform to build a solid 401(k) strategy?
[See: 13 Ways to Take the Emotions Out of Investing.]
"Modern portfolio theory is based on the premise that investors can construct portfolios comprised of multiple assets and asset classes to maximize returns for a given level of risk," says Frank Fantozzi, president and founder of Planned Financial Services in Cleveland.
While the theory can be an effective investment strategy for investors pursuing targeted long-term goals, investors often confuse the theory with ensuring the best possible returns, which is not always the case, Fantozzi says.
"Investors employing this strategy attempt to create an efficient portfolio that seeks to maximize returns for the given level of risk they're willing to take to achieve that return," he says.
"However, this approach has both benefits and drawbacks. The primary benefit of an efficient portfolio is the lower volatility or level of market risk for a given level of return. By selectively allocating a portfolio's investments to a wide variety of asset classes and securities, an efficient portfolio can effectively decrease overall portfolio risk."
Fantozzi offers a real-world example on how diversification can improve portfolio performance.
"If I lived on an island that rained 50 percent of the time but was sunny the rest of the time, and only sold umbrellas, I would do well 50 percent of the time and terrible the other half," he says. "However, if I diversified my business to sell both umbrellas and sunglasses, I could expect more sales throughout the year, regardless of the weather."
In essence, modern portfolio theory is based on the balance between risk and return.
"Basically, Markowitz stated two things with his modern portfolio theory, both premised on the idea that investors are risk averse," says Chris Georgandellis, a financial advisor with Tree Town Investments in Ann Arbor, Michigan. "He also emphasizes that, given two portfolios with equal risk measures, investors will choose the one with the greatest returns."
The questions that arise are straightforward, Georgeandellis says. How can you increase returns while keeping risk the same, or how can you reduce risk while keeping your returns the same?
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"Diversification does this," he says. "While there's a nifty mathematical formula behind it, the idea underpinning diversification is actually something of a conundrum. While most people think that the key to reducing risk is to simply hold assets that aren't risky, the opposite is the true. That is, you can make a portfolio less risky by adding risky, but uncorrelated assets to it."
"It is the 'uncorrelated' part of this statement that I find trips up investors most," Georgeandellis says.
A primary tenet of retirement investing is that diversifying your 401(k) is important because it protects you against market downturns.
"The sequence of your returns can be the difference between a successful portfolio and an unsuccessful portfolio," states Elijah Lopez, a money manager at Manske Wealth Management in Houston. "Many times, when individuals are selecting 401(k) investments they are too focused on return without considering the risk. The benefit of a well-diversified 401(k) is that while you will not receive optimum gains, you will also not be severely damaged if one sector of the market performs poorly."
If an investor's 401(k) makes up all or a big portion of their investment portfolio, diversification is especially important.
"Diversification is still critical," says Arturo Neto, founder of Neto Financial near Miami. "Even professional investors and managers don't always get forecasts right, so if a 401(k) is concentrated because of the investor's level of conviction, and they are wrong, it could be detrimental to the account and the prospects of reaching retirement goals as planned."
Neto says diversification works primarily by reducing the risk of loss by balancing the worst-performing investments with the best-performing investments over a given period.
"But not even the best of us can know which one of those is which," he says.
Tactically, the best way to diversify a 401(k) plan is to make sure that there is adequate exposure to different asset classes and geographic regions, Neto says.
"For example, having all of the equity exposure within a 401(k) in a U.S. large-cap fund, or several U.S. large-cap funds, is not good enough diversification when the economic environment favors U.S. small caps or international equities," he says.
Neto advises investors to choose one or two funds from each category within their 401(k) offerings. They are usually classified into different asset classes or regions.
"In a worst-case scenario where one is not educated enough to over/underweight certain funds, ensure that the exposure is well-distributed," he adds. "The overall market cap of the world equity markets is approximately 50 percent U.S., 40 percent international developed equities and 10 percent emerging market equities. For the more astute investor, this may be a better guideline for diversification than an equal weight approach."
[Read: How to Build a Stock Portfolio.]
More than 60 years have passed since Markowitz took his portfolio theory public. But ask a financial advisor, and he or she will tell you that the investment model has stood the test of time.
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