There’s a good reason the proverb “don’t put all your eggs in one basket” is so often used when people talk about portfolio balancing and diversification strategy. Investment issues can be highly complicated, but that phrase paints a clear and visceral picture of the risks of an unbalanced portfolio. You can pick a nice sturdy basket for those eggs and carry it carefully, but outside forces can still make you trip and lose them all.
The same thing can happen when your portfolio isn’t diversified, but it’s your retirement fund and financial safety net that are at risk. Investing across a range of asset type categories and tax categories means you’ll always have more proverbial eggs tucked away in other baskets when you need them. Put another way, creating a diversification strategy is a way of building backup plans into your backup plans.
WHAT AN INVESTMENT DIVERSIFICATION STRATEGY MIGHT LOOK LIKE
Like all investment advice, there’s no one-size-fits-all approach to diversification. How you elect to allocate your investment dollars is a personal decision that should be made based on your risk tolerance, age, current economic conditions and the guidance of investment advisors who are clear about your financial picture and goals.
Generally speaking, it might be useful to think about two types of diversification around your portfolio: asset diversification and tax diversification.
Asset diversification describes building a portfolio using assets from a variety of categories. A diversified portfolio might include all three of the main asset classes: stocks, bonds and cash/cash equivalents.
Then, the investor can create even more diversification within those assets. For example, they might invest in stocks across a range of industries and company sizes, and buy shares in mutual funds to pool their money with other stock market investors. They might also elect to buy some municipal bonds for stability, and invest in some bond funds with fluctuating returns. They might also keep an emergency fund invested in a money market account or other savings vehicle. The returns on those cash investments may be lower than for stocks and bonds, but they’re also stable.
Again, that’s just one example of what one diversification strategy could look like. Some investors might also want to add real estate or other real assets to their portfolio. Someone who’s motivated by ESG investing will look at their portfolio through that lens, which will also affect the decisions they make about where to invest. Everyone’s strategy is unique.
Tax diversification describes creating a portfolio that includes assets with different tax treatments. Making sure your portfolio includes investments from different tax categories can be a beneficial strategy for minimizing your tax burden in the current year while maximizing your tax benefits in future years.
Investments from different tax categories can serve different purposes in your portfolio:
Tax-deferred accounts: This category includes retirement accounts like 401(k)s and traditional IRAs. Funding them with pre-tax dollars can lower your taxable income for years when you make contributions, so investing in tax-deferred accounts can be a useful tax strategy in both the short term and the long term.
Tax-free accounts: These accounts include Roth IRAs, 529 plans and Health Savings Accounts. The tax benefits of investing in Roth plans and HSAs kick in once you’re retired and are able to withdraw money without paying taxes on it. Having a source of tax-free income to spend on living and medical expenses can prove very useful for retirees who live on a fixed income. And if you end up in a top tax bracket in retirement, being able to take withdrawals without paying the top tax rate on that money will be a boon.
Taxable brokerage accounts: This tax category includes stocks, bonds and other investments that aren’t tax-advantaged. After you’ve maxed out your annual allowable contributions to your tax-deferred and tax-free accounts, taxable accounts give you additional avenues to grow your wealth. And although you’ll pay taxes on capital gains and dividends, financial planners can help you craft strategies to cushion those blows.
WHY HAVING AN INVESTMENT DIVERSIFICATION STRATEGY MATTERS
Your investment advisors are the best source of information about how diversification could benefit your portfolio and your financial plan, but here are just a few reasons why diversifying pays off.
- Varying market conditions affect different investment types in different ways at different times. Some investments are more likely to perform well during times of economic volatility than others. Investing in multiple asset categories can help create some stability and help your portfolio to maintain value even if factors like inflation or other challenging conditions are hurting some of your investments.
- Diversification can help investors avoid making bad decisions out of desperation. Let’s say you need to free up some money quickly, either because of financial need or because you want to make a new investment. Having a diversified portfolio increases the chances that you have some profitable asset that you can afford to sell or cash out. If all your money is tied up in stocks in one market sector that’s currently struggling, you might have no choice but to sell them at a significant loss. (There can be upsides to selling underperforming investments at a loss, including the possibility of using tax-loss harvesting to offset capital gains and reduce your tax bill; still, profitable investments are generally the goal!)
- Diversification eases investors’ minds. Having all or most of your investment dollars tied up in high-risk assets just creates financial stress that no one needs. You’re probably going to sleep better at night if you’re not worried that your portfolio is going to collapse at any time. We’ve all seen the ways that unpredictable events change the course of some investments practically overnight. For example, say you’re an employee who invested heavily in company stock when your employee stock options vested. What would happen if your company has a huge PR crisis tomorrow, and the stock plummets? Your job and portfolio would both suddenly be at risk. That’s the kind of nightmare scenario that diversification can help prevent. It’s just easier to enjoy your money and enjoy your life when you know that you’ve put safeguards in place to protect your investments for the future.
The bottom line? Decisions about how to allocate your investment dollars are complicated and personal. That’s why it makes sense to work with your investment advisors instead of trying to balance your own portfolio. Understanding all your investment options, and the tax implications of those options, allows you to make big financial decisions with confidence.
Sachetta, LLC’s investment advisors are here to help clients make those decisions. Whether you’re brand new to investment and aren’t sure where to begin, or want to revisit your diversification strategy and rebalance your existing portfolio, we’re here to help you create investment plans that support your specific goals for the future you want. Contact us today.