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3 Crucial Diversification Decisions Can Make or Break Your Retirement

How many times have we been scolded, “don’t put all your eggs in one basket”? Today, wealth advisor Susan Elser shares the secret benefits of diversification for lower taxes and higher returns…

3 Crucial Diversification Decisions Can Make or Break Your Retirement
Image CC BY-NC 2.0 courtesy of Matt Refghi

Today we’re going to talk about the vague, not-very-helpful investing input you’ve heard a thousand times before…

You need to diversify your savings.

Don’t put all your eggs in one basket.

Rebalance your retirement accounts periodically.

And so on and so forth.

Unfortunately, a lot of the typical advice is fairly one dimensional in that it only involves allocating money to a basket of different assets.

But an article on Investopedia suggests we need to think beyond metaphorical eggs and baskets and consider the practical implications that diversification plays as part of an investor's portfolio” as well as “how a diversified portfolio is actually created.”

This article provides a practical overview of what “diversified” actually means, at least in the context of retirement savings.

Diversification across types of retirement accounts

In an interview with Indianapolis wealth advisor Susan Elser, Barron’s discussed the topic of diversification in retirement savings.

One particularly interesting part of the interview explored diversification across different types of retirement accounts:

Barron’s: What’s wrong with having all your money in a tax-deferred account?

Susan Elser: You just have to realize that with money in a pretax account you’re at the mercy of whatever ordinary tax rates are in the future. We frequently have attorneys and doctors come to us with 100% of their retirement savings, say $5 million, in a pre tax retirement account. And they have absolutely built no diversification to hedge against higher tax rates in the future...

Barron’s: After you’ve set up multiple tax buckets, how do you determine which investments go where?

Elser: ...I want my slower-growing assets in my high-tax bucket. [emphasis added]

Esler's ”pre-tax retirement account” is also known as a tax-deferred account. Generally, this means traditional IRAs and 401(k) accounts, where you don’t pay taxes on your contributions. Instead, you’re taxed during withdrawals.

Roth IRAs and Roth 401(k) accounts are the opposite. You pay taxes on your money before investing, so your later retirement withdrawals are tax-free.

You may be able to reduce some of your future tax burden by following Elser’s suggestions and put high-growth assets into a Roth IRA rather than a traditional IRA. (And vice versa.)

When you consider the various retirement account types you have at your disposal, the next step is to consider different types of assets.

Diversification and rebalancing across assets

Some people rely on the “set it and forget it” method of diversifying and rebalancing. That is, they decide and let it ride.

Elser points out that part of the benefit of having diversified savings is the possibility of higher returns. Here, she describes disciplined rebalancing of a portfolio in simple terms:

Rebalancing is one of the few documented ways to goose your returns a little bit. That’s probably the No. 1 thing that individuals do not do in managing their own portfolios.

Opening a self-directed IRA gives you the option of investing in physical gold. Since gold typically goes up when economically-sensitive decline (in other words, their prices are negatively correlated), this makes gold an excellent choice for diversification benefits.

Note also that Elser’s example involves selling assets when their price is rising. She uses the word “disciplined” to describe her rebalancing because it forces most investors to act against their instincts. In her own words, her clients mostly can’t do this themselves:

They are reluctant to buy assets when prices go down, and more eager to buy assets when they rise.

That’s the opposite of legendary investor Benjamin Graham’s first rule of intelligent investing (which he credits to Nathan Rothschild):

"Buy cheap and sell dear."

So Elser’s logical, cold-blooded “disciplined rebalancing” forces this selling-dear-to-buy-cheap behavior within a well-diversified retirement account. We specify “retirement account” because rebalancing non-tax-sheltered investments can create a bookkeeping headache, not to mention a tax nightmare.

But what about “timing” – should we wait out this period of volatility, and buy back in when the economy is “good” again?

Diversification over time

The idea that someone might be able to “timing” and only invest when the economy is “good” has long been the fondest dream of many.

But the markets are a complex and many-headed beast, virtually impossible to predict. Elser provides another perspective on market-timing:

Barron’s: You hear people say they’re waiting for the economy to get better before they get back in.

Elser: The worst thing you can do. We had several clients in their 401(k)s, which I don’t control, sell all their assets when Donald Trump won the presidency and then a different group of people sell all their assets when Joe Biden won. And neither one of those groups benefited.

Voting for a President to fail with your retirement account doesn’t seem wise. Like we said before:

Maybe we all spend too much time arguing who’s right and who’s wrong. It’s probably a better use of our time and attention to make sure our savings are diversified to benefit from a growing or a contracting economy, high inflation or low inflation. Now is a good time to consider hedging your bets, especially if you’ve already picked a side. Don’t worry about being right or wrong. Don’t let your ego stand in the way of your financial future.

A smarter approach is to diversify your retirement savings so that it’s going to provide a stable, secure lifestyle for you and your loved ones no matter who’s President, today or twenty years from now.

Turns out there’s a lot more to diversifying your savings than it seems. It’s not that boring a subject after all.

The three types of diversification

We’ve written about the 5 steps every good retirement plan should have (diversification is #5). In light of Elser’s advice, diversification is a significant consideration in every retirement plan — regardless of how boring it may sound. (The benefits seem to outweigh the boredom.)

Just remember to diversify in these three ways:

  • Account types
  • Asset types
  • Time periods

Once you start to dig in, you may find that diversification is actually an enjoyable process, one that gives you significant peace of mind even during bad economic times. As you map out your diversification plan, consider learning how gold performs over time and the benefits of a well-diversified savings plan to help earn yourself a secure, stress-free retirement.

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