How diversified do you need to be?

This article was first posted on April 1, 2000.

Limiting your retirement withdrawals to anywhere near the "100% safe" withdrawal rate leaves you with a very good chance of realizing portfolio growth well beyond your needs. For example, let's take a retiree with a 40 year pay out period and a 3.54% inflation adjusted withdrawal rate. Let us further assume an investment return of 13.67% (about the average for the S&P500 over the past 30 years) and inflation that averages 3.5% annually. The yearly portfolio values and the dollar amount of the annual withdrawals are shown in the table below.

As the table above shows, while the portfolio value has increased five-fold (i.e., from $1 million to $5.039 million), the annual inflation adjusted withdrawal has less than doubled (from $35,400 to $59,310.) These results are depicted in the graph below.

As the portfolio value increases, a retiree has several options:

• 1) Do nothing. - If you have a well diversified portfolio, or use index funds, there's no harm in staying the course -- especially if you are currently sleeping well at night.

• 2) Increase annual spending beyond the rate of inflation. - Using the Pay Out Period Reset(POPR) Method allows this. However, if you are already doing everything in retirement that you desire, additional spending may not have any value to you.

• 3) Allow your portfolio to become more concentrated. - If you follow the strategy of "let your winners ride", it is likely your portfolio will become more concentrated with the passage of time. As your portfolio value grows, the dollar amount of the "100% safe" withdrawal becomes a smaller percentage of the larger portfolio value. This decreasing percentage is called the growth adjusted withdrawal (GAW). The concept is illustrated below.
  
  
  
  As your annual withdrawal as a percentage of assets decreases, so does the minimum effective diversification required to keep the withdrawal "100% safe." In fact, the minimum effective diversification required drops rather dramatically. This phenomemon is shown in the graph below.
  
  

Effective diversification "D" is calculated using the relative value and non-market risk for each security in the portfolio. It's explained in detail in the article "Safe Withdrawal Rates for Concentrated Portfolios".

An S&P500 index fund would have an effective diversification of 50 or more. A portfolio consisting of 25% money market funds and 75% invested in the "Foolish Four" has an effcitive diversification of about 13. Replacing the 75% Foolish Four with a more volatile mix like the Motley Fool Rule Breaker portfolio reduces the effective diversification to a value of about 2 -- even though there are 14 securities in the portfolio! See the article on "Safe Withdrawal Rates for Concentrated Portfolios" for more on the details of these calculations.

There is ample evidence that holding a concentrated portfolio increases your chances of market beating investment returns. Unfortunately, it also increases your chances of under performing, or losing a large portion of your portfolio in a market downturn. Thus, this strategy should only be pursued by investors able to shoulder the risk, as evidenced by a low (i.e. 1% to 2%) withdrawal rate in retirement.