Why is Diversification Important?
Diversification is a word that often gets thrown around when speaking about investments, but what should it practically mean in your financial plan? Concisely put, diversification is a cornerstone of a wise planning strategy because it helps manage risk by spreading investments across various asset classes. Here’s a more detailed breakdown:
Understanding Diversification
Diversification involves spreading investments across different asset types to limit exposure to any single asset, thereby reducing volatility in your portfolio.
Balancing Risk and Reward
Investors should align their portfolios with their goals, risk tolerance, and time horizons:
Young investors: Should avoid being too conservative as it may lead to insufficient growth and failure to outpace inflation.
Older investors: Should avoid being too aggressive to protect their savings from market volatility, which is harder to recover from as they near or enter retirement.
Traditional Asset Classes in a Diversified Portfolio
Domestic Stocks: These are higher-risk investments with potential for high growth, but they are more volatile.
Bonds: Typically less volatile than stocks, providing regular interest income and acting as a buffer against stock market fluctuations.
Short-term Investments: Includes money market funds and short-term CDs, which offer stability and liquidity but usually lower returns.
International Stocks: Offer exposure to non-US markets with potential for high returns and risks, providing opportunities not available in domestic markets.
Additional Components
Sector Funds: Focus on specific economy segments, valuable during different economic cycles.
Commodity-focused Funds: Often helpful for hedging against inflation, and have a low correlation to the traditional stock market.
Real Estate Funds: Including REITs, help diversify and protect against inflation. Often comes with a tradeoff of less liquidity.
Cryptocurrency: Even experts have wide ranging opinions on what type of asset class this falls into. At present, any form of cryptocurrency comes with a high degree of volatility and speculation. But there can be a suitable place for it in a portfolio, for investors with a high risk tolerance.
Asset Allocation Funds: These funds maintain specific asset allocations and can be tailored to various goals like retirement or income generation.
Impact of Diversification on Volatility
Diversification primarily aims to limit volatility, not necessarily to maximize returns. For instance:
An aggressive portfolio (60% US stocks, 25% international stocks, 15% bonds) might have high returns but also high volatility.*
A slightly more balanced portfolio (49% domestic stocks, 21% international stocks, 25% bonds, 5% short-term investments) historically offers slightly lower returns with reduced volatility.*
Adjusting Allocation Over Time
As time progresses and goals approach, adjusting the asset allocation to reduce risk is crucial. For example:
Approaching retirement might mean reallocating from stocks to bonds and short-term investments to protect against market downturns.
Even in retirement, maintaining some growth-oriented investments is essential to combat inflation and avoid outliving assets.
Tax Diversification
This is an area often overlooked in financial planning but is every bit as important as investment diversification. These are some examples of accounts in different tax buckets:
Pre-Tax Accounts: This would include retirements accounts such as a 401(k) and Traditional IRA. Any contributions to these accounts are a tax deduction, with income tax being owed when funds are distributed. These are most effectively used when an investor is in a high tax bracket during their working years, and a lower bracket during their retirement years when the funds are being withdrawn.
Post-Tax Accounts: The most common form of these accounts are a Roth IRA and a Roth 401(k), which are growing in popularity. These essentially work the opposite of the pre-tax accounts, with contributions being made from after-tax funds. These contributions then grow tax-free, and the distributions are tax-free, assuming the IRS rules regarding these accounts are followed. This can be particularly useful for keeping your taxable income in a lower tax bracket during your retirement years, especially when lump sums may be needed for a one-time purchase.
Taxable Accounts: This would include most types of non-retirement accounts. These accounts do not include the same tax advantages that retirement accounts receive. They are funded with after-tax dollars, and the growth is subject to capital gains tax when the positions are sold. However, the trade-off is higher liquidity and fewer rules. A brokerage account is not subject to age restrictions on distributions or contribution limits.
Bonus Account: A health savings account (HSA) is referred to as a triple tax advantaged account. The contributions are a tax deduction, the funds can be invested with no capital gains tax, and the distributions are tax-free if they are used for qualified medical expenses. In the right situation, current medical expenses can be funded out-of-pocket, allowing an HSA to grow and be utilized as medical savings account in retirement.
Regardless of specific goals, time horizons, or risk tolerances, a diversified portfolio helps manage risk and is fundamental to any investment strategy. By balancing various asset classes, investors can achieve a more stable and potentially rewarding investment experience over time. By diversifying in different tax buckets, investors can more efficiently manage their tax burden in retirement, when it matters most. Our team's priority is to ensure our clients are efficiently utilizing both forms of diversification.
*Facts sourced from: Fidelity.com “Why Diversification Matters”
Investment advice is offered through Belpointe Asset Management, LLC. 500 Damonte Ranch Parkway, Building 700, Unit 700, Reno, NV 89521 All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.