4 steps to diversifying your investment portfolio


By Hannah Szarszewski, CFP

I know. You’ve heard this word a thousand times and you understand that you shouldn’t put all your eggs in one basket. It’s great that we agree because diversification is a big deal. But what is often overlooked are the many ways diversification comes into play. Here are four ways that create the most value when implemented correctly.

Hannah Szarszewski

Diversify with fixed income and equity allocations

In most cases, it’s better to have both fixed income and stocks in your portfolio than having 100% of one or the other. The split between the two depends entirely on your personal circumstances. Having some diversification between the two is helpful for many reasons.

First of all, it is useful for rebalancing. Rebalancing occurs when your fixed income and equity allocations need to be adjusted to your target. For example, if your target is 60% equities and 40% fixed income, and your portfolio is currently weighted at 70% equities and 30% fixed income because the stock market is rising, you will rebalance your target. Conversely, if the market is correcting and your equity allocation is below your target, you would sell fixed income securities to buy equities. Have the ability to sell fixed income securities and buy stocks at better prices allows you to potentially benefit from a greater gain over the long term. Note that in the short term the market might go down, so this is a long term strategy.

The potential additional return resulting from resetting your portfolio’s current weighting to target is called a rebalancing premium. When you rebalance, you are selling profits on assets that have recently outperformed and 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 is not as great.

Second, no expert can perfectly predict the market consistently 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 prolonged corrections. For example, from 1969 to 1982, three-month Treasury bills outperformed the S&P 500 (on a total return basis)! Young investors have never experienced this kind of long-term underperformance with stocks, but it can happen! In cases like this, it would be very common to question your strategy if you had 100% equity. This is another reason why having fixed income and equities is a solid approach.

Plus, when you hold both fixed income and equities, you give yourself more flexibility in ANY market if distributions are needed. For example, if you need to distribute funds in a bear market, you can sell bonds instead of stocks and reduce the permanent loss (if any) from selling during a correction.

Diversification with account types

Having different types of accounts with different tax implications is also an important part of diversification. If managed in a tax-efficient way, it can potentially reduce your overall tax burden. It also offers flexibility with distributions. To achieve tax diversification, you can have a 401(k) or IRA (most often pre-tax funds are paid out and when distributed are taxed as ordinary income), a Roth IRA (the after-tax funds are paid out and all growth is tax-exempt if distributions qualify) and a taxable brokerage account (short-term capital gains are taxed as ordinary income and capital gains at term are taxed at the reduced capital gains rate).

The location of assets is one of the advantages of this type of diversification. Asset location involves placing different assets in different types of accounts to improve tax efficiency. For example, it is optimal to place (non-municipal) bonds or bond funds in a 401(k) or IRA account, 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 may vary depending on the details of your financial situation. It may be optimal to hold stocks or stock funds in your Roth IRA because the expected long-term growth is higher than other asset classes and everything would be tax-free upon distribution (as long as the distributions are qualified). It’s generally better to keep real estate funds in a 401(k) or IRA because they’re tax inefficient and over the long term they underperform stocks (so growth wouldn’t be as beneficial in a Roth IRA). These are three broad categories, but tax efficiency varies across different subclasses of an asset class. This is a substantial area of ​​optimization when you have diversification with account types.

Having different types of accounts also enhances tax planning opportunities when distributions are needed. If you only have a 401(k) and IRAs, the distributions will be taxed as ordinary income and there’s not a lot of flexibility around that. If you have an IRA and a taxable brokerage account, you have the ability to choose which account to distribute from. With this flexibility, you can potentially reduce taxes overall, as 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 best performing countries for equities in 2020 were South Korea and Denmark. In 2019, these were Russia and Egypt. If you look at the data for the last ten years on this, you will notice that there is no trend. So if you only invest in US stocks, you are missing out. It’s good 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, so it’s wise to have exposure to several.

Diversification with holdings

This is probably what you’ve heard the most about. Being concentrated on a few individual stocks or bonds significantly increases your risk. Depending on the investments, your portfolio could fall to zero and not recover. Being invested in a multitude of securities spreads this risk and therefore reduces the overall risk. The best way to be fully diversified is to invest in ETFs or mutual funds.

The sectors are also a component not to be neglected. What I regularly see is excessive concentration in the technology sector. While the technology has done well and needs to be represented, it’s not always the top performer. In 2018, healthcare was the best performing sector for US equities and in 2016 it was energy. It is better to have exposure in different sectors to benefit from the best performers and also to reduce risk – win-win.

Different asset classes and subclasses are another way to diversify. Depending on the size of your portfolio, it may make sense to add various subclasses to increase your exposure to different market environments. On the fixed income side, you can include a global bond fund, a US corporate bond fund, or an inflation-protected Treasury bond fund. For US stocks, you can 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 is not always necessary.

The term diversification may seem overused, but that’s because it’s such a powerful way to optimize portfolio management. When fully utilized, it reduces risk and 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 backgrounds to help them achieve financial independence and live life to the fullest.

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