When someone is trying to get a plan together for the long-term, so that they can retire comfortably, there are a few challenges that stand in the way.
- Paying higher FEES on their retirement accounts, such as a 401K plan through their company. There are a lot of folks out there who have no idea what they are paying on FEES for their 401K plan.
- NOT losing 20% or more of their retirement account when the markets suffer a financial crash like we had back in 2008.
- Getting returns off their investments, that actually BEAT the rate of inflation throughout time. (Inflation on average over the last 30 years has averaged out around 3.4 – 4% annually).
- Outliving their income that they withdraw from their 401K or retirement accounts.
These are just a few of the challenges that we all face when we are thinking of retiring. Most folks would agree that the #1 concern for them is having INCOME when they are no longer working. Income is the ultimate tool we use for survival. The #1 rule to investing is NOT to lose your money, so how do we reduce our risk so that we don’t lose as much and still provide ourselves with a decent enough return so that we have income still coming in when we retire?
It’s simple…it’s called risk diversification.
What is risk diversification?
Diversification is the act of spreading your money into various investments across different industries or sectors, to reduce the amount of risk of losing your money over time also called (risk diversification).
There is a lot of controversy over this topic from many different investors and personality types within the financial world. You will hear some say that diversification is “the one sure way to lower your returns intentionally” and you will hear others say “that diversification is the only way to build wealth indefinitely”. In our humble opinion, we think both views are probably right however if we had to choose not making as much in returns and lowering our risk of losing our money or taking on greater risk for higher returns and higher odds of losing our money… we would choose to lower our risk so we don’t lose as much of our money. Another term for this process is called ASYMMETRICAL RISK/REWARD. This decision and the process is based on (#1 rule of investing) don’t lose your money.
So with this rule and process in mind, as the foundation for building wealth, it would only make sense to come up with a portfolio diversification strategy. Again… it ultimately comes down to your personality and your appetite for how much risk tolerance you will accept for losing money because the one thing that is guaranteed, at one point in time or another, is that you will take on some losses with your investments. The question you have to ask yourself is, how much risk are you willing to take for the reward?
Risk Parity and Asset allocation
In regards to a portfolio diversification strategy, the first step is focusing on the “Asymmetrical/Risk-Reward” aspect of your portfolio and to allocate funds to different asset classes. This process will reduce the risk of losing money throughout time due to a few challenges that all investors face. Throughout time, a few things are for certain when it comes to market volatility and the constant change of pricing assets.
- Higher than expected inflation
- Lower than expected inflation (or even deflation)
- Higher than expected economic growth.
- Lower than expected economic growth
Based on the four challenges listed above, the goal is to create a portfolio that reduces risk, in any of these four environments and still gives the investor the chance at making a return on their money. This is precisely what Ray Dalio, has been able to achieve with his asset allocation for his hedge fund company, Bridge Water Associates. If you are not familiar with who Ray Dalio is, he owns the world’s largest hedge fund in the world and has been called on many times to help Central Banks and governments around the world, reduce risk in times of financial crisis.
The main goal is to acquire assets such as bonds, stocks and commodities. According to Ray Dalio you then want to position yourself in such a way, that regardless of what happens in the markets, your portfolio value isn’t exposed to HUGE losses. We want to avoid taking heavy losses when the markets take a nose dive like they did back in August of 2015, the flash crash of 2011 and back in 2008 during the financial crisis.
The all weather fund and a balanced portfolio
Too many people are familiar with taking 40% or more losses, in market environments like we have seen in the last decade or so. Some of this is due because of too much exposure in one asset class such as stocks. Let’s just look at the 401K for example….there is a HUGE majority of folks who are having their 401K’s managed by fund managers. One might assume that the correct portfolio balance is usually 50% stocks / 50% bonds and that is balanced right? Think again!
This 50/50 allocation may look balanced but in terms of RISK PARITY or your positions having balanced RISK exposure to one asset class, this is wrong according to an interview that was done by Tonny Robbins on Ray Dalio. The 50/50 portfolio allocation may do well over the short term but we are not interested in short-term performance. According to Ray Dalio, if you are 50% invested in stocks or equities, you are realistically setting yourself up for around 95% RISK in equities or stocks and 5% RISK in bonds. For an explanation of this claim watch the video below.
So the conclusion here is that a BALANCED asset allocation has everything to do with actually increasing your chances of making returns while decreasing your chances of losing BIG. With something like an all weather portfolio, you are basically finding a specified asset allocation that works in any market theoretically. If you would like you can share your opinion on this for portfolio theory and a balanced portfolio in the comments below.
Disclaimer: We are NOT saying that this is the ONLY way to get better returns while reducing risk. We are simply researching options for better ways to obtaining a balanced portfolio based on risk parity so that investors can KEEP more of their money throughout time, that is invested for retirement.