Why Investing Solely in “Safe” Assets May be Riskier Than You Think
When many investors envision building a retirement portfolio, they often think of constructing that portfolio by investing in "safe" exchange-traded assets, like stocks and bonds. Alternative assets, such as commodities or real estate, are often viewed as being “too risky” to hold in an IRA that will be relied upon to provide a steady income stream once retirement arrives.
While this may come as a surprise, there's a chance that limiting your portfolio solely to “safe” assets like stocks and bonds could be a riskier strategy than you think.
A seemingly "safe" investment is made risky by violating a cardinal rule of investing: diversification. The heavy concentration in a few stocks means the investor is missing out on an opportunity to mitigate the risk of big losses by spreading money around.
A recent Bloomberg story, which was called, "How 'Safe' Investments Could Destroy Your Portfolio," highlights the danger of this approach. After years of low interest rates and rising stock markets, Bloomberg says conservative investment strategies might be putting investors at risk. Here are two examples it provides:
- Dividend-paying stocks: Bloomberg said an analysis of 300,000 portfolios by investment firm SigFig showed that most clients who were focused on income relied on only a handful of dividend-paying stocks to deliver that income. Among investors age 40 and older, roughly half held three or fewer stocks. Nearly one-third relied on a single stock for income. In this example, Bloomberg said a seemingly "safe" investment is made risky by violating a cardinal rule of investing: diversification. The heavy concentration in a few stocks means the investor is missing out on an opportunity to mitigate the risk of big losses by spreading money around.
- Seeking yield in the wrong places: During periods of low bond yields, income-hungry investors may be tempted to purchase assets that are over-priced and poorly understood, Bloomberg said. For example, an investor may be attracted to the riskiest junk bond because of its bigger payout, but these are bonds are issued by struggling municipalities that could default. High-yielding stocks may also attract investors in a low-yield environment because they have a generous payout, but Bloomberg says there's a chance the company might be able to keep paying that dividend.
One reason to consider including alternative assets in your self-directed IRA is diversification. Adding alternative assets to a traditional portfolio of stocks and bonds has the potential to reduce risk and volatility, improving long-term returns. The reason for this is correlation, or the tendency for certain asset classes to rise and fall together. Studies have shown that alternative assets move somewhat independently of stocks and bonds, and they may increase in value if stocks and bonds fall. The effects of correlation were on display during the 2008 financial crisis when -- much to the shock of many investors -- stock and bond portfolios suffered heavy losses.
78% of surveyed advisors believe alternative assets are an important part of asset allocation, while 33% said they allocate 10% of their client assets to alternatives.
An RIA Database survey of roughly 1,000 financial advisors found that 78% of surveyed advisors believe alternative assets are an important part of asset allocation, while 33% said they allocate 10% of their client assets to alternatives.
Do alternative assets belong in your self-directed IRA? Every investor has to make his or her own decisions based on risk tolerance and income requirements.
A financial professional can help you learn more about alternatives and whether they have a place in your portfolio.
PENSCO’s Blog is purely for educational purposes. PENSCO does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Individuals are encouraged to seek professional advice before making any investment decision. Investments are not FDIC insured and are subject to risk, including the loss of principal.