By Hannah Szarszewski, CFP
I know. You’ve heard this word a thousand times and you understand not to put all your eggs in one basket. It’s great that we agree because diversification is a pretty big deal. But what’s often overlooked are the many different ways that diversification comes into play. Here are four ways that create the most added value when implemented correctly.
Diversification with fixed income and equity allocations
In most cases, it’s optimal to have some fixed income and some equity in your portfolio rather than having 100% of one or the other. The allocation between the two entirely depends on your individual circumstances. Having some amount of diversification between the two is helpful for many reasons.
First, it’s helpful for rebalancing. Rebalancing is when your fixed income and equity allocations need to be adjusted back to your target. For example, if your target is 60% equity and 40% fixed income, and your portfolio is currently weighted at 70% equity and 30% fixed income because the stock market is up, you would rebalance back to your target. Conversely, if the market is in a correction and your equity allocation is lower than your target, you would sell fixed income to purchase equity. Having the flexibility to sell fixed income and purchase equity at more favorable prices allows you to potentially benefit from a larger gain over the long-term. Note that in the short-term, the market could dip lower, so this is a long-term strategy.
The potential additional return from resetting your current portfolio weighting back to target is called a rebalancing premium. When you rebalance, you’re selling profit from assets that have recently outperformed and you’re buying assets that have recently underperformed. This encompasses the idea of buying low and selling high. If you have 100% equity in your portfolio, the rebalancing premium opportunity isn’t as great.
Next, not one expert can perfectly predict the market in a consistent manner over time. However, we know the market will go up and down. As you know, with diversification the ups and downs are smoothed out. What is often underestimated is the anxiety resulting from extended corrections. For example, from 1969 to 1982, three-month treasury bills outperformed the S&P 500 (on a total return basis)! Young investors haven’t experienced this kind of long-term underperformance with stocks but it can happen! In instances like this, it would be very common to question your strategy if you had 100% in equity. This is another reason that having some fixed income and some equity is a solid approach.
Also, when you have both fixed income and equity, you give yourself more flexibility in ANY market if distributions are needed. For example, if you need to distribute funds in a down market, you can sell bonds rather than stock and reduce the permanent loss (if any) from selling during a correction.
Diversification with account types
Having different account types with different tax implications is also a significant part of diversification. If managed in a tax efficient way, it can potentially reduce your overall tax liability. It also provides flexibility with distributions. To achieve tax diversification, you could have a 401(k) or IRA (most commonly pre-tax funds are contributed and when distributed, they are taxed as ordinary income), a Roth IRA (after-tax funds are contributed and all growth is tax-free if distributions are qualified), and a taxable brokerage account (short-term capital gains are taxed as ordinary income and long-term capital gains are taxed at the reduced capital gains rates).
Asset location is one benefit of this type of diversification. Asset location is placing different assets in different account types to improve tax efficiency. For example, it’s optimal to place (non-municipal) bonds or bond funds in a 401(k) or IRA as opposed to a taxable brokerage account because they include interest and ordinary dividends, which are taxed as ordinary income. Note that the best strategy can vary based on details pertaining to your financial circumstances. It may be optimal to hold stocks or stock funds in your Roth IRA because the long-term expected growth is more than other asset classes and it would all be tax free when distributed (as long as distributions are qualified). It is usually best to keep real estate funds in a 401(k) or IRA because they are tax inefficient and over the long-term they underperform stocks (so the growth wouldn’t be as beneficial in a Roth IRA). These are three broad categories but tax efficiency varies with different subclasses in an asset category. This is a substantial area for optimization when you have diversification with account types.
Having different account types also improves tax planning opportunities when distributions are needed. If you only have a 401(k) and IRAs, distributions will be taxed as ordinary income and there isn’t a lot of flexibility around that. If you have an IRA and a taxable brokerage account, you have flexibility with which account to distribute from. With this flexibility, you can potentially reduce taxes overall because you can plan around tax brackets and impact your total taxable income for the year.
Diversification with domestic and foreign investments
This is a separate category because it is so common for someone to only want to invest domestically. However, the top performing countries for equity in 2020 were South Korea and Denmark. In 2019, they were Russia and Egypt. If you look at the past ten years of data for this, you’ll notice that there isn’t a pattern. So, if you’re only invested in United States equity, you’re missing out. It’s great to have confidence in our economy but benefiting from returns all over the world is an advantage of diversification. We don’t know which countries will be on top from year to year which is why it’s wise to have exposure to many.
Diversification with investment holdings
This is probably what you’ve heard about most. Being concentrated in a few individual stock or bond holdings significantly increases your risk. Depending on the investments, your portfolio could go to zero and not recover. Being invested in a multitude of holdings spreads out this risk and as a result, reduces risk overall. The best way to be fully diversified is to invest in ETFs or mutual funds.
Sectors are also a component that shouldn’t be ignored. What I see regularly is an over concentration in the technology sector. While technology has performed well and should be represented, it’s not always the top performer. In 2018 health care was the top performing sector for U.S. equities and in 2016, it was energy. It’s best to have exposure in different sectors to benefit from the top performers and also to reduce risk – win win.
Different asset classes and subclasses are another way to diversify. Depending on your portfolio size, it may make sense to add various subclasses to increase your exposure to different market environments. On the fixed income side, you could include a global bond fund, a U.S. corporate bond fund, or a treasury inflation-protected bond fund. For U.S. stocks, you might add a large-cap value fund or a small-cap fund. Additionally, real estate mutual funds and ETFs are an asset class included in the equity allocation and they can improve diversification. Note that real estate stocks are usually included in total market stock funds so an additional fund isn’t always necessary.
The term diversification may seem overused but that’s because it’s such a powerful way to optimize the management of a portfolio. When utilized to the full extent, it reduces risk and it can increase long-term returns.
About the author: Hannah Szarszewski, CFP®
Hannah Szarszewski is a CERTIFIED FINANCIAL PLANNER™ Professional and Accredited Financial Counselor® Practitioner. She is the founder of Blue Mountain Financial Planning, LLC and focuses on integrating financial coaching and education into the financial planning process. She has partnered with clients of all ages and various walks of life to help them achieve financial independence and live life to the fullest.