Why is it important to diversify your investments? The answer is simple: to manage risk. Diversifying your investments is about more than holding different stocks and bonds. Full diversification involves all of your assets: homes, stock options, retirement accounts, and so on. If you’re wondering how to diversify your investments, consider every asset you own as one portfolio and approach diversification from the top down.
Why is it important to diversify your investments?
Because no one has a crystal ball, and if you did, you wouldn’t be reading this article on how to diversify your investments. 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.
As these charts show, if a large part of your assets are concentrated in one thing, you could risk losing it all if you miss the mark. That ‘thing’ could be any asset: rental properties, Tesla stock, small cap equity, or a sector, such as financials.
The easiest way to explain why it’s important to diversify your investments is the dot-com bust in the early 2000s. Sharp reversals in the stock market can come at any time, for any reason. Take a look at the impact on oil, airlines, and hotels following the Coronavirus outbreak in early 2020.
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.
How to diversify your investments
Diversifying account types: 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 pre-tax contributions to a 401(k) reduce your taxable income and grow tax-deferred. Contributions to a Roth IRA or Roth 401(k) don’t reduce tax today but can be withdrawn 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.
Asset allocation and 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 have many underlying holdings all in one fund, based on a 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, don’t assume it will stay that way. After your new asset allocation is in place, you need to periodically rebalance your portfolio. Over time, as your assets gain or lose value in the market, your allocation shifts. 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 more risk and less diversification. Rebalancing is the process of recalibrating your asset allocation.
The final misconception is that you need to diversify each account separately. 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, consider whether each account needs to have its own complete asset allocation.
So for example, instead of buying an ETF that tracks the S&P 500 in all 4 of your accounts, perhaps you invest 50% of one account in the ETF. While the other accounts may not own any of the S&P 500 ETF, you still hit your asset allocation when the accounts are rolled up to one portfolio.
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. While holding real estate for personal use or investment may be a good component of your investment strategy, be cautious about over-investing.
Locking up a large part of your net worth in illiquid investments can create 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.
The illiquidity of real estate reduces your financial flexibility and you’re also subject to the volatility of the real estate market. When you invest in stocks or REITS, the most you can lose is your initial investment. When you hold real property and it becomes worthless, you still need to pay the mortgage.
Diversification doesn’t mean avoiding losses. There isn’t always somewhere to hide in the financial markets
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 company 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 too much cash will yield a real negative return (after inflation and taxes). If you have way more cash than you need for your ongoing expenses, emergency funds, etc., 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 takes time and ongoing monitoring to balance risk and reward while investing. If you’re wondering whether it’s a good time to invest – remember, it’s about time in the market, not timing the market.
Diversifying your investments with the help of a wealth advisor
At Darrow Wealth Management, we help investors develop a cohesive approach to asset management. During the onboarding process, we work to help simplify your financial life by consolidating accounts and bringing old retirement plans back into the forefront. To learn more about our Private Wealth Management Program, please contact us today.