In preparation for my seminars this week on retirement income, I wanted to have a brief discussion about the science around financial planning. Focusing on how we can make more money with less risk is one of the ways I fell in love with financial planning. The mathematical concept is known as “coefficient of variation” which is defined as “a measure of spread that describes the amount of variability relative to the mean”. In lamens terms, this means that by breaking up your assets (diversification) into riskier investments, you’re actually able to lower your risk and increase your rate of return! It’s because of this concept that we are able to come up with advanced types of diversification to improve your overall performance. It’s how you can sustain an 8%+ average rate of return on market while not being hit with the negative exposure on the downside like you would if you were simply invested directly into the S&P 500 as a whole.
What this allows us to do as advisors is to take your estate, determine when, and by how much, you will need your funds and to adjust your investment allocations accordingly. This is how we’re able to make you more money, reduce your risk, and overall earn the assets under management fee you begrudgingly pay us for all of this work. It’s also about diversifying amongst different categories. For example, if you have all of your money in tech stock, you are too exposed, and under diversified, in the event something happens to the tech world. So money needs to be spread out amongst finance companies, real estate companies, etc. so that you get a relatively safe upside performance.
Keep in mind that no one has a crystal ball. We can’t predict what will happen to individual companies and short term reactions on the market. It’s because of this that diversification is so important. It’s not about making 8% in one year, but making 8% average every year consistently. Market investing is long term, not short term. If you try to be a day trader, you will add anxiety to your life and ultimately, your performance won’t be as great as you think it will. This is why we use diversification, and methods of understanding how to diversify, to reasonably approach investing based upon need.