There are 2 major risks that investors face: The first is a risk to principal. The second is purchasing-power risk. Savers are more concerned about risk to principal. Investors are more concerned about purchasing-power risk.
Savers can avoid risk to principal by putting their money in savings accounts insured by the Federal Deposit Insurance Corp. or by investing in U.S. Treasury securities.
While U.S. Treasury securities can fluctuate in value, the face value of the investment is guaranteed by the U.S. government to be paid at maturity.
What’s all this got to do with time diversification? Read on.
A different type of portfolio diversification
Vanguard’s Investment Counseling & Research put out a paper titled “Time Diversification and Horizon-Based Asset Allocations.”
It defined time diversification as “the concept that investments in stocks are less risky over longer periods than shorter ones.”
Matching financial goals to investment horizons
I’ll typically advise people with shorter-term investment horizons to look toward savings as the way to reach those short-term goals versus putting their money in the stock market.
Conversely, investors looking to fund their retirement typically have longer-term investment horizons, and have “rebuilding years” where they can recoup their investment losses.
Workers early in their careers have decades available to them to save for retirement. They have to worry about earning a real return on their retirement investments. A real return is a return that exceeds the inflation rate. They expect to recoup losses to principal but worry about the ravages of inflation on their portfolio.
Retirees have a long investment horizon, too
What’s interesting on the retirement-planning front is that now that investors may not have a pension in retirement, but just Social Security, retirement savings and perhaps some home equity, they are being advised not to dial down risk as much as they approach retirement. That’s because, given life expectancies and retirement income needs, they still have a long investment horizon that could be more than 30 years.
Risk-averse investors need to save more
Now, throw into the mix the level of risk tolerance that investors have toward volatility in their portfolio. The risk-averse investor is looking to avoid loss to principal but still faces the impact that inflation will have on savings. Those risk-averse investors will need to save more to fund their retirement.
That’s the problem with 401(k) plans replacing pensions as a vehicle for retirement savings. The individual has to make decisions on contributions to fund a retirement lifestyle, with or without the help of a financial professional, and doesn’t have the ability to make sufficient contributions or to make sound financial decisions.
Do you count on-time diversification to recoup market losses over the long run?
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