It is simply a reality that market conditions play a significant role in retirement planning for almost everyone. Generally speaking, the more diversified you are, the less impact market events will have on your retirement plans.

If you happen to retire immediately before a prolonged bull market, there really isn't anything to worry about. However, if you end up retiring prior to a bear market, your retirement dreams could crumble if your portfolio is unprepared. Regrettably, there is no way to determine if you'll be retiring into either a bull or bear market. With that in mind, let's take a look at how to prepare your portfolio no matter what the market throws at you.

Rate of Spending vs. Rate of Return
To begin, keep in mind that a successful retirement portfolio is one that provides a steady and growing stream of income. To accomplish this, you must set a realistic and sustainable spending rate - the percentage of your portfolio that you remove each year to pay for living expenses. The spending rate must allow your portfolio's growth to offset inflation. Generally speaking, most investment professionals would consider a 4-5% spending rate to be a realistic target, implying a total return needed of 6.5-7.5%, assuming 2.5% inflation. (To learn more, read Curbing The Effects Of Inflation.)

In order to achieve this rate of return, a substantial allocation to equities is necessary; probably about 50% of your portfolio. Unfortunately, when you shift from fixed income into equities, you significantly increase your portfolio's overall risk. This increased risk translates market value and spending volatility.

Retirement certainly isn't a time when you want to have huge swings in your income level. Because there is no way to know in advance if you're retiring into a market upturn or downturn, it is best to prepare your portfolio by seeking as much diversification as possible.

The Importance Of Diversification
To illustrate the crucial role of diversity, the following table shows the performance and spending power of a non-diversified portfolio starting at the beginning of the most recent bear market (2000).

Non-Diversified Portfolio
Performance and Spending Power
-- Market Value
Of Portfolio
Annual
Return
(%)
Annual
Spending
@ 5%
Inflation
Adjusted
Spending
Dec-99 $1,000,000 -- -- --
Dec-00 $960,751 1.1 $50,000 --
Dec-01 $896,577 1.7 $48,038 $51,693
Dec-02 $792,574 6.6 $44,829 $52,496
Dec-03 $879,814 16.0 $39,629 $53,747
Dec-04 $903,092 7.6 $43,991 $54,757
Dec-05 $891,904 3.8 $45,155 $56,538
Dec-06 $963,174 10.0 $44,595 $58,469
The following assumptions were incorporated into this table:
  • A non-diversified portfolio is defined as 50% S&P 500 and 50% Lehman Aggregate Bond;
  • Index performance is shown, not any actual investment vehicle;
  • The rate of inflation is assumed to be the actual CPI (consumer price index);
  • Retirement begins on January 1, 2000 with a $1-million portfolio; and
  • 5% of the portfolio is spent every year based on the beginning market value that year.

As you can see from the table, a non-diversified portfolio would not have fared well during a bearish market environment. Most notably, even after six years such a portfolio would be substantially lagging an inflation-adjusted rate of spending.

This is why creating a truly diversified portfolio is so essential for retirees. One of the most common investor mistakes is assuming holding different mutual funds provides diversification. This isn't necessarily true. Many mutual funds offer virtually identical investment exposures. Also, holding individual stocks or bonds doesn't necessarily provide ample diversification either, especially if those securities are in the same asset class. (To learn more about these problems, see Disadvantages Of Mutual Funds and Diversification Beyond Equities.)

The Benefits of Diversification
True diversification involves holding investments in various asset classes and styles of investing, and not placing too large a bet in any one area. Here is a comparison of the of a asset distribution for non-diversified portfolio with one that is invested across multiple U.S. and international asset classes.

Asset Class % Allocation
S&P/Lehman
Bond
Diversified
U.S. Large 50 15
U.S. Mid -- 5
U.S. Small -- 5
International Large -- 15
International Small - 5
Emerging Markets -- 5
Total Equities 50 50
U.S. Lehman Aggregate Bond 50 20
U.S. Inflation Protected Bonds -- 15
International Bonds -- 15
Total Bonds 50 50
Total 100 100

As mentioned before, diversification does not offer complete protection against a market downturn, but it can substantially mitigate its effects.

How To Get There
Fortunately, achieving a meaningful level of diversification really isn't all that hard as long as you keep a few fundamental ideas in mind.

1. Don't rely on individual stocks and bonds. Individual investors (and brokers) are sometimes ill-equipped to research and monitor enough individual securities to provide proper diversification. Serious investors, like colleges and foundations, hire money managers (or mutual funds) to achieve diversification. Take a lesson from them.

2. Never use a single mutual fund family regardless of how good it seems. Generally speaking, mutual fund families tend to have a consistent investment process across their products even though the names of their funds are different. Though their process may be worthwhile, having professionals with different viewpoints on investing is another essential aspect of diversification.

3. Don't put all of your money in one style of investing such as value or growth. These investment styles will go in and out of favor depending on market conditions. Diversifying against these market trends is very important, as these trends can easily last five years or more and produce vastly different rates of return. (For more diversification tips, read Portfolio Protection In Diversification And Discipline.)

In addition to these diversification tips, you need to be extremely conscious of fees because they represent a structural impediment to success. For example, retail mutual funds may charge 1-2%, and brokers may charge 1-2% as well for wrap accounts. This means total fees can be between 2-4% per annum, which comes directly out of your investment performance. One great way to avoid fees is through an index fund provider or ETFs, which can generally provide a fully diversified portfolio for about 0.50%. Moreover, by investing in index funds you will achieve very broad degrees of diversification within a given asset class. (To get started, see Three Steps To A Profitable ETF Portfolio and Uncovering The ETF Wrap.)

Conclusion
It is essential for investors to realize that market conditions, and timing thereof, can play a major role in their retirement plans. Since it is impossible to anticipate how markets will behave, diversifying your assets is simply the most prudent course of action. Take an active role in your portfolio, and do it by diversifying your assets and picking good mutual funds in which to invest your money. Such activities are most likely the best use of your time.

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