After setting long-term financial goals, such as living comfortably during retirement, you may be deciding how best to invest your money to reduce risk and increase your earning potential. One way to mitigate risk and defend against a potential financial crisis is to diversify your assets and investment portfolio. In this article, you’ll learn more about asset diversification, including types to consider when planning your financial future.
What is diversification?
Diversification is the adage: “Don’t put all your eggs in one basket.” In practice, it means spreading your money among and within various investments to reduce risk as opposed to investing in only one asset class (such as stocks, real estate, or cash).
An important aspect of diversification is asset allocation or deciding how much of your portfolio will be invested in each asset class. You’ll allocate your investments to stocks, bonds, cash equivalents, and other asset classes.
You will also diversify within each asset class. One way to do this is by buying stock in a wide variety of companies, industry sectors, geographical regions, and more. You may also purchase bonds from various governments and corporations with different terms.
Diversifying within a particular asset class can be challenging, so you may find it easier to do so through a mutual fund. A mutual fund is a corporation that pools money from investors. The fund invests that money in stocks, bonds, and other securities, making it easy to own stock within an asset class.
By diversifying among and within asset classes, you can receive a mix of returns, balancing your investments over the long term. This makes it more likely for you to achieve your financial goals.
The importance of diversification
Diversification is an essential tool for managing investment risk. If you overemphasize a single security or asset class, you are exposed to significant losses. By diversifying, however, you lower that risk so that, ideally, the positive performance of one investment will neutralize the negative performance of another.
Additionally, you may be able to reduce fluctuations in returns for a more predictable outcome. This can be achieved by creating a well-diversified investment portfolio containing assets that react to economic events independently of one another.
Diversification is also important because it may impact whether you meet your financial goals. If your portfolio does not include enough risk, you may not receive a large enough return to meet your goals. However, if you have too much risk, your money may not be available when you need it.
Pros and cons of diversification
As with any investment strategy, diversification has its advantages and disadvantages. And it’s crucial that you understand them to make the best investment decisions to help achieve your financial goals.
Pros of diversification
The primary benefit of diversifying your assets is that it helps minimize the risk of a significant loss. If one of your investments does not perform well during a particular period, you have other investments that may do better during that same period.
Diversification also protects you from market volatility. Volatility is when a market or security experiences periods of unpredictable movements, and it’s an important aspect of the stock market. For an investor to see good returns and profits, the market needs to trend upward. But that doesn’t always happen. Diversification minimizes the risk that a market experiencing a downturn could produce.
By diversifying your assets, you may increase the chance of hearing positive news from your investments. You will not just hope to hear favorable news specific to one company. Instead, you could learn any positive news that may impact one of the companies in your portfolio in a beneficial way. This gives you more opportunities for a return, especially if you have a diversified portfolio over a long period of time.
Additionally, you will not rely on just one source to generate income, which is especially great if one of your investments does perform as expected.
It’s crucial to realize that diversification can produce these benefits only if the assets in your portfolio are not perfectly correlated. In other words, your holdings should respond differently to market influences and economic events.
Cons of diversification
Although there are many advantages to diversifying your investment portfolio, there are also some disadvantages.
One of the primary disadvantages is that the strategy works both ways; not only will you spread out your risk, but you will also spread out the reward. This means that you may only generate average returns.
Because you have multiple investments, managing your portfolio can be more challenging. Investing in a mutual fund can help you overcome this potential downside because an experienced portfolio manager will likely manage your investments for you.
It can also be more costly to diversify your portfolio because you will have to pay transaction fees and brokerage commissions to maintain the asset allocation you defined in your investment plan. This is called rebalancing, which is buying and selling investments to realign your asset allocation to your original target.
Types of diversification
You can diversify your investments in different ways, including asset and account diversification.
What is asset diversification?
Asset diversification means owning assets in various categories of investments. You can diversify among different asset classes and within a single class. The primary idea behind asset diversification is that what negatively impacts one asset class may benefit another.
Examples of asset diversification
To understand asset diversification, it’s important to know the various options you have to diversify.
The first way you can implement asset diversification is to diversify among various asset classes, which include the following:
- Stocks, which are shares or equity in a publicly traded company
- Bonds, which are government or corporate fixed-income debt instruments
- Real estate, such as land, buildings, and water and mineral deposits
- Commodities, which are basic goods necessary for the production of other products or services, such as precious metals
- Cash and short-term cash-equivalents, such as treasury bills, certificates of deposit, money market vehicles, and other short-term, low-risk investments
Besides diversifying among various asset classes, you can also diversify within a single asset class across various industry sectors. Different sectors generally operate differently, so spreading your assets among industries will mean that overall, your portfolio is less likely to be impacted by sector-specific risk.
You can also diversify based on the size of the company. In general, investing in a smaller company may be riskier, but there is also more growth potential. Larger, more established corporations, on the other hand, tend to be safer investments but will likely have smaller returns.
Another option is to diversify based on a company’s physical location, such as foreign versus domestic. For example, events that may cause the U.S. economy to decline may not affect the German economy. This can give you a small cushion of protection during a recession. Additionally, you may consider diversifying between emerging and developed nations.
You can also diversify by investing in tangible and intangible assets. Intangible assets cannot be physically touched and include asset classes like stocks and bonds. Tangible assets, such as real estate and commodities, can be physically touched and have real-world applications. They tend to have different investment profiles than intangible assets because they can be consumed, rented, or developed. But they can also be vandalized, stolen, or damaged by natural forces.
Pros of asset diversification
The benefits of asset diversification are essentially the same as the overall benefits of investment diversification.
- By diversifying your assets, you can reduce the risks of experiencing a significant loss.
- Asset diversification also helps create stability if the market is too volatile.
- You will have multiple investments that could generate income instead of relying on just one source.
Cons of asset diversification
There are some disadvantages to choosing asset diversification.
- If you diversify your assets, you risk reducing your overall earning potential.
- Asset diversification does not always work. For example, during the 2008 financial crisis, almost every major asset class experienced a downturn, and asset classes that historically reacted differently reacted similarly.
- Occasionally, you will increase your overall risk by diversifying your assets. This is especially true if you invest in certain hedge funds whose volatility cannot be predicted.
What is account diversification?
Account diversification refers to strategically allocating your assets among each of the three tax buckets: taxable, tax-deferred, and tax-free.
- Taxable accounts allow you to deposit funds that have already been taxed. There is no tax incentive when you deposit or invest your money, and interest, dividends, and capital gains will be taxed as income or at a reduced rate for long-term capital gains. Taxable accounts include savings accounts, taxable brokerage accounts, and rental real estate.
- With tax-deferred accounts, you will not pay taxes when you contribute but only when you withdraw your funds. You will typically receive a tax deduction for investing your money in one of these accounts, so the benefit is on the front end. Tax-deferred accounts include 401(k)s, 403(b) accounts, 457(b)s, thrift savings plans (TSPs), traditional individual retirement accounts (IRAs), simplified employee pension (SEP) IRAs, savings incentive match plans for employees (SIMPLE) IRAs, and annuities.
- With tax-free accounts, you will pay taxes on the funds before investing them. Then, when you access the money, you don’t have to pay taxes on the withdrawal. Tax-free accounts include Roth IRAs, Roth 401(k)s, Roth TSPs, and cash-value life insurance.
To learn more, read “Types of Retirement Accounts.”
Example of account diversification
It’s crucial to determine how much money you will need to have saved by the time you want to retire. Once you know that amount, you can make a plan to diversify your assets among different account types.
You may, for example, start your career by investing in a Roth IRA so that you’re taxed on the funds before they’re invested. As your income increases and your tax bracket changes, you may choose to invest in a traditional IRA or 401(k). Then, you may start prioritizing saving into a taxable account, such as a savings account. Ideally, by the time you retire, you will have about a third of your retirement savings in each tax bucket so that you have the flexibility to withdraw from each account based on your circumstances and tax needs at the time.
Pros of account diversification
Many people may gravitate toward a particular account type, such as a tax-deferred 401(k), but there are several benefits to diversifying your assets across multiple account types.
- You will have more control over your overall finances. Taxable and tax-free accounts don’t have distribution requirements, so you can control how much you withdraw. Tax-deferred accounts, on the other hand, often have required minimum distributions starting in the year you turn 73. This gives you the flexibility to decide when to lean only on income from your tax-deferred accounts and when to add income from your other accounts into the mix.
- By utilizing account diversification, you can potentially lower the amount you’ll pay in taxes throughout your lifetime. You will be able to spread out your taxable distributions over time to keep more of your savings.
- Taxes are nearly impossible to predict in the future lifetime. If most of your investments are in a tax-deferred account, you risk paying much higher tax rates in the future. By spreading out your investments, though, you have a safety net if tax rates rise.
- Account diversification allows you to prioritize your investments based on your current situation. For example, when you’re younger, it may make sense to focus on investing in a Roth IRA because your income will generally be lower, and thus your taxes will be lower. Then, as your income increases, you may begin prioritizing a tax-deferred account because you want the tax benefits when you invest your money. And you may also start investing more in a taxable account, so you have cash readily available for an emergency.
Cons of account diversification
As with any investment strategy, there are also some disadvantages to account diversification.
- There is a chance that you will be in a lower tax bracket when you withdraw your funds than when you invest them. If that’s the case, you could be paying more in taxes for funds added to a taxable or tax-free account.
- Rebalancing is an essential part of diversification. If you have to sell some of your assets from a taxable or tax-deferred account to rebalance your portfolio, you risk paying a significant amount in taxes.
Make diversification part of your financial plan
Diversification is an essential concept to consider when determining your investment strategy and during financial planning. To learn more, read “What Is Financial Planning?”