One Way How Portfolio Diversification could Impact Our Retirement

There are many reasons why we should diversify our investment portfolio. One of them is to reduce the fluctuation of our asset value. The statistical term for fluctuation is standard deviation.

Standard Deviation of Returns, Not Prices.

It is the standard deviation of the asset returns we are reducing not asset prices, because it would not make sense that the standard deviation of asset return is 0, which means that the asset value neither goes down nor goes up.  Asset with price standard deviation being 0 will not generate any return.

On the other hand, it is meaningful to reduce the standard deviation of asset returns. For example, stock A, with a mean return rate of 5% and a return rate standard deviation of 10%, can generate a return of 5%, 4%, 0% or -10% this year. 

But we don't want the -10% return happening, we can add some other investment asset who is negatively corrected or not corrected with stock A, say cash, assuming cash has a mean return rate of 0% and a return rate standard deviation of 0%.

Furthermore, cash return is not corrected with stock A, because however stock A price moves would not affect cash price, which stays the same regardless.

Calculating the Portfolio Standard Deviation

If we have an investment portfolio of 70% stock A and 30% cash, our investment portfolio will have a mean return of 5% X 70% = 3.5% and a return rate standard deviation of 10% X 70% = 7% 

Math Derivation for Standard Deviation of 2 Assets

Why is it Important to Lower Fluctuations for Our Retirement Portfolio Returns

One big important reason is that we don't want to use up all our retirement money to soon. We will have still have to withdraw money from the retirement portfolio even when its value drops due to short-term stock market turbulence.

It is possible we use up our retirement money too soon if its return rate standard deviation is too big.

Therefore, it is important to lower the standard deviation of our retirement portfolio return rate.

simulator

This simulator simulates when the retirment fund is used up.

Stock rate of return:

 % 

Cash rate of return:

 % 

Standard deviation of stock return:

 % 

Standard deviation of cash return:

 % 

Cash holding ratio:

 % 

Amount of retirement fund：

 k dollars 

Annual withdrawal:

 k dollars

Portfolio rate of return:

 % 

Standard deviation of portfolio rate of return:

 % 

 

After 0 years, the portfolio value is 0K dollars, you are broke！