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Craig Israelsen, an associate professor at Brigham Young University, wants us to know that it pays to build "Steady Eddy" portfolios for retirement.

The question: If common stocks provide a 10 percent return over the long run, why can't I spend 7 percent a year and leave 3 percent to compensate for inflation? Why do all these planners tell me I can spend only 4 percent? Where does that lost 3 percent go?

For most people, it just doesn't seem right.

The statistical answer, which is less than illuminating, is that the lost return went down the variance sink.

Another way of looking at it is that the 3 percent is the price of market volatility.

Build a more stable portfolio, and you'll pay less for market volatility – the inevitable ups and downs of asset prices.

You'll sleep better. You'll raise the odds you can spend more each year.

To demonstrate the idea, Dr. Israelsen tested the impact of increasing diversification on retirement portfolios. The portfolios were set for an initial withdrawal rate of 5 percent, with the original dollar withdrawal amount increasing by 3 percent each year thereafter, to account for inflation.

Using the period from 1970 to 2006, he examined both the statistical stuff (standard deviation and internal rate of return) and the scary stuff (worst single-year loss and frequency of one-, two- or three-year losses of 10 percent or more).

Guess what?

A portfolio with seven asset classes not only has a higher return than a simple domestic equity portfolio, it also has about half as much risk.

His two-asset portfolio – 50/50 U.S. large- and small-cap stocks – produced an annualized internal rate of return of 10.7 percent. But it lost a deadly 30.8 percent in its worst year.

His seven-asset portfolio – equal portions of U.S. large- and small-cap stocks, international stocks, U.S. intermediate fixed-income, cash, REITs and commodities – provided an 11.25 percent return. But the worst-year loss was only 10.2 percent.

When he observed that some portfolios appear more diversified than they are, I asked for an example.

"We can have a portfolio with U.S. large-cap and EAFE [international stocks], and it will look diversified. But it isn't in terms of timing – the timing of return is too similar. Diversification is really like an engine. Each asset class is a piston. It's important that they fire at different times."
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