The Cash Flow Clock: For Retirees - Book - Page 28
The Cash Flow Clock
2. Diversification: This is used to reduce risk by spreading it among
different asset classes, assuming that each one will perform differently
under different market conditions. This may be true, if the assets are
not too closely correlated (i.e., they don’t grow and lose in similar
ways and at similar times). Most portfolios are limited in the
investments that they can use and default to the standard mixes of
stocks, bonds and mutual funds. There is value of spreading out risk
to avoid losses. But when portfolios are overly diversified, they are
just as likely to avoid gains as losses.
Many investment plans include hundreds of holdings, most of which
are mutual funds or exchange traded funds which contain hundreds or
even thousands of investments inside each one. How can we avoid
loss if our portfolio includes so many investments?
The Cash Flow Clock eliminates risk for the next 10 years of expected
income which buys our Risky investments time to grow efficiently.
Because we are not trying to use Risky assets for income, we can
focus on investments that have the highest and most consistent upside,
typically large cap stocks. With enough Lazy and Safe investments, a
focused Risky portfolio of individual large cap stocks typically
provides all the diversification we need for efficient growth.
3. Rebalancing: Because Asset Allocation is based on risk tolerance and
age, the target portfolio diversification doesn’t change very much or
very often. The recommended allocation for a 60-year-old
conservative investor is not much different when they turn 65.
However, the performance of the different asset classes is likely to be,
well, different. Which means the actual allocation percentages, over a
short amount of time, will start to drift away from the target.
This issue becomes more of a problem as assets are used for income.
To limit this disparity, the portfolio is regularly and, in many cases,
automatically, rebalanced to bring it back in line with the target
allocation.
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