When you graduate from work to retirement, it’s an emotional time. It’s right up there on the stress meter as one of the most stressful times in your life. It’s right up there with graduating from school and getting into the real world.
How about some other stressful times financially? How about getting married? Or having children? All are examples of the happiest times in our lives, but now, financially, more lives depend on you.
When we’re young, we just plow ahead. We try to save enough to make a down payment on our first home. And for many of you, interest rates were much higher than they are today. Somehow, you and your spouse made the payments and got through it with some kitchen table talks.
Then, for retirement savings, you had more investment properties, or you had a savings plan through your work. Whatever the case, you built up your pile of money for when you retire. You put your head down and got to work.
Now you’re in or approaching retirement, and you can’t just set it and forget it. You need to be more thoughtful about how you’re going to live off your savings, understanding you don’t have the time like you once did to make up for mistakes.
This is where the Efficient Frontier comes in, or how to allocate your portfolio for what is right for you. The Efficient Frontier, created by Harry Markowitz in 1952, measures the efficient diversification of investments that delivers the highest level of return at the lowest possible risk. Investors must consider the trade-offs between risk and reward in their portfolios. You can see on the chart below an efficient frontier line representing risk vs. reward for a portfolio allocated between different proportions of stocks and bonds using data back to 2000.
On the vertical axis is the return earned by the portfolios, and along the horizontal axis is a measure of how much risk was taken to earn those returns. As you can see by comparing the portfolio of 80% bonds and 20% stocks to the portfolio of just bonds, as portfolios take on a small number of stocks, the benefit of diversification lowers risk and increases reward. Anything above the line is unachievable because no portfolios earning those returns are available at the corresponding risk levels. And any portfolios that fall below the line can be outperformed with the same amount of risk or have their returns matched with less risk.
But to achieve higher returns along the line, investors adding more stocks to their portfolios are taking on ever greater amounts of risk. A portfolio of 100% stocks boasts a standard deviation of over 14%. Be aware of the risk in your portfolio and manage it wisely.
Action Line: The Efficient Frontier is a backward-looking series, but it is also a good example of how asset allocation can help in times of trouble. It’s a snapshot of how risk has affected portfolios through time. When you want to talk about risk and your portfolio, email me at ejsmith@yoursurvivalguy.com. Click here to subscribe to my free monthly Survive & Thrive letter.
Read the entire series here.
Originally posted on Your Survival Guy.
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