The value of diversification in retirement
At the heart of goals-based investing is building a portfolio that accommodates for the risks and needs of a specific investment goal. If for example the investment goal is to draw regular cashflows to pay for one’s retirement, several portfolio features become important such as tax optimisation, access to liquidity, inflation protection, but most importantly - managing downside risk for this investment goal is vital.
The advantage of investing in an actively managed goals-based fund such as the AMP Capital Core Retirement Fund* is that the portfolio attributes are aligned to the needs of the investment goal, as opposed to traditional active or passive index funds which are agnostic to the type of investor and their investment goal and therefore cannot customise portfolio attributes around tax, liquidity, inflation and downside risk to the needs of retirees.
Diversification is central to effective downside risk management and therefore forms an important part of our retirement investment strategy. The motive for diversification in a portfolio is a natural concept to many people - we’re all intimately familiar with the old adage that warns against putting all our eggs in one basket. But what does diversification mean in this context and how much does diversification help reduce losses when markets fall? Can we label a portfolio entirely invested in equities but highly diversified across its stock holdings as diversified?
Diversification: Smooths but does not necessarily increase returns
For those who have saved their nest egg and are more concerned with consistency of cash flows rather than growth, diversification is a crucial strategy to achieve these investment goals. What it is not is a strategy that will guarantee superior returns under every market condition.
Rather, investors in highly-diversified funds should hope to match or better the performance of a passive multi-asset whilst experiencing lower volatility from period to period. In the short term, diversified funds will sometimes underperform equivalent, less-diversified funds, especially if a particular asset class where competitors are comparatively concentrated has a strong period of growth. However, they will be less exposed during asset or sector-specific downturns.
As an example, we conducted scenario analysis on the AMP Capital Core Retirement Fund and a traditional passive index 50/50 fund to assess the expected changes in portfolio values through a simulated 2008 Lehman Brothers collapse. The below chart highlights the importance of diversification and risk management in limiting losses in stressed environments to mitigate sequencing risk.
Expected changes in portfolio values through historical stress events
Diversification in different stages of retirement
The defensive positioning made possible by diversification is especially important early in the life of a retirement fund, where the underlying value of the asset is more exposed to sequencing risk. This refers to a situation in which an early decline in the value of the asset, the need for an annual withdrawal of funds to meet living expenses, and the lack of a capacity to top up the holding with external income, eats away at the core value of an asset in a way that significantly affects its ability to generate future cash flows. Highly diversified funds are less exposed to sequencing risk than their less-diversified counterparts.
It is important to note that under normal market conditions diversification cannot eliminate risk from a portfolio. Even the most well-diversified funds are still susceptible to market risk, tail risk (the risk of an extreme market event), inflation risk and liquidity risk. The latter is particularly important with retirement funds, in which the option to time withdrawals can be limited.
At times of market stress diversification can become less effective as correlations rapidly increase. A well-managed and diversified retirement fund will utilise other methods to deal with these particular risks, including defensive asset allocation, tail risk hedges, inflation hedges, and where appropriate, a preference to income stocks that generate after-tax cash flows for investors.
A high level of actively-managed diversification is a must-have attribute for any investor entering retirement for whom consistency of income from their portfolio is a priority. Goals based funds offer the opportunity to achieve this with a scale and sophistication normally unattainable for the average individual investor or passive index strategies.
*AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity of the AMP Capital Core Retirement Fund (Fund) and the issuer of the units in the Fund. To invest in the Fund, investors will need to obtain the current Product Disclosure Statement (PDS) from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232 497) (AMP Capital). The PDS contains important information about investing in the Fund and it is important that investors read the PDS before making a decision about whether to acquire, or continue to hold or dispose of units in the Fund. Neither AMP Capital, AMPCFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this document, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to their objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.