Ice cream is amazing, but if you eat ice cream and only ice cream, you’re going to have a hard time. That’s why experts recommend a balanced diet that incorporates a host of different foods and at various portions to achieve a healthy, balanced lifestyle.
The same is true for your finances. Putting all your investment dollars into stocks or a single sector of the economy won’t yield the best results for your long-term financial health. Rather, as history shows, it’s better to build a portfolio that includes a variety of asset classes. That’s diversification in a nutshell.
Here’s a closer look at how diversification works in investing.
What is diversification in investing?
Let’s start with investments. A diverse portfolio will include a varying proportion of stocks (large, small, U.S. and global), Treasury bonds, cash equivalents, commodities, and more. Each asset class behaves differently depending on the economic backdrop, sentiment in markets, Federal Reserve policy, global unrest and more. Bonds, for example, tend to perform better when stocks are on the ropes. Commodities can help investors keep pace with inflation, as material costs are often a source of inflation.
Essentially, diversifying a portfolio is a means to managing risk in a world that is unpredictable. For every expected outcome, the world throws us surprises — so-called, unknown unknowns. What’s true today is rarely true a year from now, much less 10 years from now. Times change, and so do leading asset classes. With strategic diversification, you’ll already be in position to capture some upside when sentiment shifts.
The trick is to determine an asset allocation that balances risk and reward in a way that’s appropriate for your investing timeline. That’s why it’s often helpful to work with a financial advisor who can help assess your risk tolerance and your goals to tailor a portfolio to your aspirations.
In addition to diversifying the assets you invest in, the accounts in which they are held is an important component of long-term financial health. Your employer-sponsored 401(k) allows you to contribute to your retirement before income taxes are taken out. That’s a nice advantage today, but when you retire your withdrawals will be considered taxable income.
Contrarily, when you contribute to a Roth IRA, for example, income taxes have already been taken out of the dollars you contribute. However, the money will grow tax-free and won’t be considered taxable income in retirement. Having money stashed away in accounts with different tax treatments can give you flexibility to manage your tax bracket in retirement. That can help your savings go further in retirement tomorrow while also allowing you reap tax benefits today.
Diversifying risk exposure
You can also tuck savings away in assets that grow (and decline) with the market or in financial tools that are completely removed from the market. Investments held in a 401(k) and IRA are exposed to the market. On the other hand, whole life insurance provides a death benefit for your family and also includes a savings component known as cash value. This is guaranteed to grow over time^ — regardless of what happens in markets — and can become a source of cash down the road1. It’s another layer of flexibility in your plan.
Diversification isn’t always easy
Building a diversified portfolio isn’t necessarily difficult; however, it takes discipline to stick with it. Asset classes go in and out of favor (there will always be a top- and lowest-performing asset class each year). Logically, that means you’re going to own some asset classes that don’t perform well — sometimes, for quite some time.
By its very design, a diversified portfolio will never outperform the top-performing asset class, but it also won’t finish at the bottom. Rather, it should reliably produce middle-of-the-road returns relative to any single asset class. But it’s not easy to stick with a “loser” or see negative returns in your portfolio when the financial press and pundits are talking about the latest, greatest growth trend.
Outside of your investments, whole life insurance also adds unique component to a plan. Although not a investment itself, when compared to the returns of safer assets you can expect the guarantees will be a helpful component of your financial plan2. That can be a source of strength, stability and peace of mind over the long term. Building tax diversification into your plan may require paying a little more today to reap benefits further down the road. Strategically building a well-diversified, long-term plan is all about balancing these tradeoffs in a way that best suits you.
That’s where a trusted, knowledgeable financial advisor can help. The places you choose to invest in are important, but your behavior plays an equally important role in building wealth over the long term. An advisor can help you see through the noise and stay focused on the big picture. Not only can they build out a diversified portfolio that’s tailored to you or your goals, their objective perspective and experience can help instill confidence to stick with your plan through thick and thin. You’ll be equipped with a plan with a range of financial options that gives you flexibility today and in the future.
1The primary purpose of permanent life insurance is to provide a death benefit. Using cash values through policy loans, surrenders, or cash withdrawals will reduce benefits and may affect other aspects of your plan.
2 Cash value accumulates slower in the earlier years of the policy to cover the cost of insurance. it will take many years for your policy’s accumulated value to reach the cost basis
All guarantees are backed solely by the claims-paying ability of the insurer.
All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against a loss.