Proper diversification of your investments requires more than just holding a diversified portfolio. If you're wondering how to diversify your investments, consider every asset you own as one portfolio and approach diversification from the top down.
Because no one has a crystal ball, and if you did, you wouldn't be reading this article on how to diversify. Diversification matters because as much as investors want to "beat the market," they also really want to send their kids to college, buy a bigger house or a vacation home, travel, and retire one day. If a large majority of your assets are concentrated in one stock, asset class, or investment, you could risk losing it all if you miss the mark.
By holding a diversified portfolio of investments and assets that aren't perfectly correlated, the goal is to achieve sustainable growth over the long-term while mitigating your risk (and losses) through over-exposure to any one asset. You may not pick the next unicorn but at least you didn't jeopardize Junior's college fund.
Still want the unicorn?
We get it, taking a prudent approach to long-term wealth creation isn't exactly sexy. If you're the type who likes to gamble or play around in the stock market; do it. Some of our clients even have "play" accounts where they take a small portion of their investable assets and try their hand with single stocks. There's nothing wrong with that as long as you understand the risks and don't inadvertently bet the proverbial farm.
Diversify your portfolio
Retirement vs non-retirement accounts
To diversify your portfolio, it may make sense to consider holding assets in a number of different types of accounts. Tax-deferred retirement accounts like a 401(k) or tax-deductible contributions to an IRA can reduce your taxable income today and provide tax-deferred growth if held to retirement. A Roth IRA, Roth 401(k) or after-tax contributions made to a traditional IRA will be made with after-tax dollars but become tax-free in retirement. A taxable brokerage account offers investors the greatest flexibility, but no tax benefits. Used together, it is possible to develop a strategy for tax-efficient withdrawals in retirement and avoid the RMD tax cliff.
Investment management strategy
Setting your asset allocation properly is the most important component of diversifying your investment accounts. There are also a number of misconceptions about diversification that can be misleading to investors.
First, the number of funds or securities in your portfolio is not necessarily linked to how diversified it is. Target-date retirement funds are designed to be a diversified basket of securities for investors all in one fund, based on their target retirement date. Target-date funds have their merits, but come with a much higher expense ratio for the service.
Second, even after you're diversified your portfolio, there's no reason to assume it will stay that way. After your new asset allocation is in place, you will need to periodically rebalance your portfolio. Rebalancing is necessary because over time, as your assets gain or lose value in the market, your intended portfolio composition will shift over time and you may be invested much differently than you intended. Since stocks tend to fluctuate more rapidly than bonds, a 70/30 portfolio could become 90/10 if left unbalanced over time, which exposes you to much more risk and far less diversification.
The third and final misconception is that you must hold a diversified portfolio in each individual account. Depending on the makeup of your various accounts, this may not be necessary, or even advisable. Rather, focus on diversifying your investments and holdings across all accounts in aggregate. To reduce trading costs, it may make sense to choose only a portion of the ETFs or mutual funds you've selected for each account, so that in aggregate, you achieve your desired asset allocation.
Read more on ways to develop your asset allocation and the components of a successful investment management strategy
Diversifying your investments is about more than just your portfolio
When it comes to real estate, don't forget about 2008
Many investors have a fascination with real estate. Perhaps it's the glitzy home shows or the idea of creating a passive income stream of rental income that seem too tempting to pass up. However, it is important for investors to remember that while holding real estate for personal use or investment may be a good component of your overall strategy, it shouldn't comprise the vast majority of it.
When individuals lock up a large part of their net worth in illiquid real estate investments, it can cause a domino effect of other financial risks. Even though the real estate market is strong now, events like the collapse of 2008 can happen again. In fact, if you have tried to get a mortgage recently or use your home's equity, you may have already noticed the lending policies are once again becoming more relaxed and certain types of loans unavailable after the crash are popping up again.
The illiquidity of the real estate market can significantly reduce the flexibility you might need for your finances, and you're also subject to the full volatility of the real estate market. Unlike investing in stocks or REITS, where the most you can lose is your initial investment, when you hold real property and it becomes worthless, you are still required to keep paying the mortgage.
Don't over-invest in company stock
There are a number of ways investors end up over-doing it in employer stock:
- Compensation package is too heavily weighted in company stock options or awards
- Company 401(k) plan match is in shares of the employer's publicly traded stock instead of cash
- Once stock options are exercised or awards are vested, all shares are held instead of liquidated
- Participating too heavily in an employee stock purchase plan
- Purchasing shares of employer stock independently for personal accounts
Individuals are often hesitant to let go of their company stock and diversify the proceeds into other investments. Having faith in your employer is a good thing – but having all your eggs in one basket usually is not. If you’re holding onto your equity in hopes of a large windfall, make sure you’re also comfortable with the possibility of losing your on-paper profits too. Financial markets can be volatile, and news of a merger, acquisition, and shifts in legislation and commodity prices can have a dramatic impact on stock prices, sometimes overnight.
In general, no more than 10 percent of your net worth should be in employer stock. If your compensation package is too heavily weighted in company stock options or awards you can try to renegotiate to receive more cash compensation.
Cash isn't always king
In the low interest rate environment of the last decade, holding cash will yield a real negative return (after inflation and taxes). Yet there are circumstances where it is advisable to stay liquid, especially when you have a major purchase on the horizon. If you have way more cash on hand than you reasonably need for your ongoing expenses, emergency reserves, and other liquidity needs, consider putting it to work for you.
Diversification typically can't be achieved overnight unless you have a large sum of cash to invest. It often takes time and ongoing monitoring to ensure you are maximizing your potential wealth creation without taking on unnecessary risks.