Diversify the way you think about diversification

By Vanguard

Investing strategy

 

Investors can employ diversification strategies beyond just asset allocation

From the Bible to Aesop’s Fables to modern portfolio theory (MPT), the concept of diversification—not putting all your eggs in one basket—as a means of reducing risk has been around for more than 3,000 years.

But investors and the financial advice industry often focus solely on diversification across asset classes within a portfolio.

It’s important to broaden that view to include wealth management strategies—specifically, to reduce exposure to the uncertainty of future taxes and planning horizons.

Diversification is an acknowledgement that we can’t predict the future. It’s also a means of hedging that uncertainty.

Diversification reduces risk and regret

Diversification is nothing new. The Talmud, for example, advised people to evenly divide assets between business, cash, and land.

Harry Markowitz, the Nobel laureate and father of MPT, took the concept to another level, showing that diversification can potentially generate higher returns with lower risk. Perhaps that’s why diversification is often said to be the only free lunch in investing.

Diversification is an acknowledgement that we can’t predict the future. It’s also a means of hedging that uncertainty.

This is why we buy a basket of securities rather than concentrate in a single one, hold both domestic and foreign assets, and allocate to stocks and bonds in proportion to one’s risk tolerance.

This diversification story has become a key tenet of building prudent investment portfolios and is a crucial element of Vanguard’s Principles for Investing Success.

Still, let’s acknowledge that hindsight is 20/20. An investor can always look back to see where they could have made more money. But diversification helps minimise that regret.

 

Diversification goes beyond portfolio construction

The benefits of diversification extend beyond one’s investment portfolio. Two critical elements of wealth management stand out: tax risk and longevity risk.

These risks tend to be acknowledged but don’t necessarily apply the powerful concept of diversification to mitigate them.

But, by diversifying the way we think about diversification, we can help reduce our risks.

 

What tax diversification looks like

What will your tax rate look like in the future? It’s hard to know, when changes like marital status, income level, and required retirement withdrawals can easily push people into unexpected tax territory—and that’s assuming no changes to current tax laws.

A diversified approach that spreads assets across accounts with different tax structures can help reduce some of that risk. Further, a tax-efficient approach when contributing to and withdrawing from investment portfolios can lower the overall costs of investing.

Strategies could include using a mix of before-tax and after-tax super contributions to manage tax exposure before and during retirement.

Of course, there’s no one-size-fits-all approach when it comes to tax diversification. The ideal mix of assets depends on an investor’s goals, timeline, and expectations for future tax concerns. Costs matter, and diversifying can help lessen what’s arguably one of the largest expenses associated with investing: the impact of taxes.

 

Income diversification reduces longevity risk

Living beyond one’s life expectancy is a wonderful problem to have but a potential nightmare from a wealth management standpoint.

Retirees and pre-retirees want to know how much they can spend today while making sure they’re saving enough for the future.

A diversified approach to retirement income, supported by savvy portfolio allocations and spending strategies, can help offset longevity risk while still fully enjoying life.