You may not be able to predict what life has in store for you, but you can build a safety net to protect you and your loved ones when the unexpected happens (like a job loss, major illness, or global pandemic). You’re building wealth to fund your retirement lifestyle and leave a legacy for your loved ones. When your financial advisor talks about diversifying your investments, it’s to help you achieve greater financial security by protecting your wealth from devastating losses.
You can diversify your portfolio through the types of investments and accounts you choose, also called asset allocation and asset location.
Asset allocation refers to the types of investments you choose and the percentage of your money you invest in each asset class, such as stocks, bonds, cash, cash and equivalents, and real estate. By dividing your money between the different asset classes, you can maximize profit potential and lower risk.
Say, for example, that you invest one-third of your money in the stock market, one-third in bonds, and one-third in a certificate of deposit. Doing this helps protect your money. If you keep all of your money in a certificate of deposit or money market fund, you will not have to worry about losing it when the stock market dips. But you also won’t see great returns and even run the risk of inflation chipping away at your investments.
At the same time, putting all of your money in the stock market may not be a good idea. You can see impressive returns if you choose the right stocks, but you also increase your level of risk. Dips in the market can erode your investments, and if you’re too close to retirement, you may not have enough to fund the lifestyle you want.
Primary asset classes include:
These classes can be further divided into subclasses:
Asset location denotes where you keep specific assets in your portfolio. This includes the decision to choose tax-advantaged (traditional and Roth IRAs, 401(k) and 403(b) plans), and taxable (brokerage) accounts. Another aspect of asset location is choosing the right account for each investment because different investments are taxed at different rates. Like asset allocation, asset location is a tool used to diversify portfolios.
Tax-advantaged accounts include tax-deferred and tax-free options. A tax-deferred account lets your money grow tax-free until you start withdrawing from the account. This includes traditional 401(k) plans and IRAs, SEP, and SIMPLE IRAs. With a tax-free account, you pay taxes on your investment money before putting it in the account. Roth IRAs, Roth 401(k)s, and Roth 403(b) accounts are tax-free.
You buy and sell stocks, bonds, exchange-traded funds, and index funds through a taxable investment account. This may be through an online broker or robot advisor. The gains and dividends you receive through the account are taxed at your standard income tax rate or the capital gains tax rate.
Tax-efficient investing strategies help you reduce the amount of money you pay in taxes on your investments by paying taxes when you’re in your lowest tax bracket. That may be now or after you retire. Ideally, you could put all of your money in tax-advantaged accounts, so you lower your tax liability when you start withdrawing and have more money in your pocket for expenses. Unfortunately, contribution limits restrict how much money you’re allowed to invest in these accounts, so that’s not an option.
All investments come with a degree of risk, and a lot can happen on the way to retirement. Asset allocation and asset location help you achieve diversification that protects your investment along the way. Having your money in a variety of investment vehicles increases the likelihood you can hold on to your cash and see returns even when a particular sector of the economy or market struggles.
You can put additional investment strategies to work within the broader categories of asset allocation and asset location. In doing so, you can maximize the potential strength of the subclasses to boost returns, protect your investment, and leverage tax liability.
Some investors purchase bonds from various issuers, such as the federal government, state and local governments, and corporations to balance out the returns they expect to receive. Even within these categories, they may look at the terms and credit rating of each issuer when making a decision. They also may consider purchasing bonds with different maturity dates to produce a stream of returns over a given period of time.
Diversifying real estate takes several forms. Some investors choose to purchase real estate in different locations. Others focus on a single market. Another option is to purchase properties in different sectors, including single-family residential, commercial, industrial, and multi-family. Real estate mutual funds and real estate investment trusts are options for those who don’t want to own physical property.
Investors may balance their stock holdings by spreading their investments across market capitalization, such as large-cap, mid-cap, and small-cap stocks. This helps them avoid losses when one class of stocks underperforms since there is no way to know for sure which stocks will perform well from year to year. Another option is to divide stocks by sectors, such as technology, manufacturing, and utility companies.
Achieving diversification in your portfolio isn’t a one-time action. Your needs and risk tolerance change over time, and your portfolio should reflect those changes. Milestones—marriage, births, deaths, job changes—serve as reminders to revisit your investments to ensure they’re appropriate for where you are in life. As you get closer to retirement, you may need to lower your risk exposure. Your financial advisor also may recommend meeting at regular intervals, such as every six months or every two years, to check in.
The choices you make regarding asset allocation and asset location are personal decisions. What is right for one investor may be disastrous for another. This is why it is important to research your options and consult with a professional who can evaluate your individual needs and assist you in making these decisions.