Are You Diversified?

Being diversified is much more difficult than spreading money among several financial advisors or a few different investments. Good diversification is like a painting. Although many different hues of paint are used, each color is deliberately placed to contribute to the congruent final product. To be well-diversified requires an investor to examine their goals, how investments correlate, and the impact of taxes.

Set Goals

The National Endowment for Financial Education recommends that any diversification of investments begins with a discussion of goals. How you decide to diversify depends on where you want to end up. To diversify appropriately, make sure investments in the portfolio have a specific time frame that matches your goals.

While stocks are good investments for long term savers, they fluctuate too much to be useful for short term goals. Conversely, guaranteed investments such as money markets are good ways to protect short term opportunities, but have returns that are easily beatable for long term needs.

Compute the specific amount of cash needed to reach each goal. This amount, when compared to the starting nest egg, will help you compute how quickly investments need to grow. In essence, you’ll know whether to choose an aggressive or conservative mix of diversified investments.

Investment Correlation

Often, investors think they’re diversified because they have a mix of many different mutual funds or stocks. Surprisingly, many funds hold similar stocks. Likewise, many stocks move in tandem.

If you hold Exxon Mobil stock, any other oil company would add little diversification to the portfolio. Likewise, because Exxon Mobil is in the S&P 500, any other stock in this index wouldn’t diversify a portfolio as much as a stock in a mid-cap or small-cap index. Exxon Mobil, as an international conglomerate, also fluctuates based on international pressures, so this stock doesn’t help balance a portfolio against international companies as much as one that only operates domestically.

Because Exxon Mobil is in the oil business, it isn’t surprising that there is a strong correlation between the fluctuations of Exxon Mobil stock and oil prices. Investors seeking diversification by adding a natural resources fund to the portfolio will find that precious metals and timber fan out the portfolio risk more than adding funds with oil or gas.

Use this approach with each position in the investment portfolio to determine how much correlation there is among investments. Identify holes that’ll need to be plugged and overlapping investments that should be sold.

Move Outside your Comfort Zone

Often, diversification means exploring areas of the investment landscape you hadn’t considered. A recent ABC News poll revealed that 89 percent of the 77 million people lumped as “baby boomers” in the United States didn’t think they were on course for retirement. People hoping to send children to college or save for a first home also often find themselves with more goals than money. If you need to be aggressive about diversification, carefully plan out some calculated risks if reducing the end goals doesn’t seem to be a good idea.

To remain aggressive, skilled investors research many different investment categories to avoid large bets. Instead of taking a single risk in a hot sector such as technology, wise investors diversify risk into several different categories. That way, if one investment sours, the rest of the bets in the portfolio don’t fall prey to the same problem.

One investment category that some investors find uncomfortable is precious metals. On their own, precious metals fluctuate much more than stocks. However, studies have shown that a small allocation of precious metals added to a diversified portfolio can return significant results. In a 2007 study commissioned by the CFA Institute, researchers found that purchasing the stocks of precious metals companies added significantly to the returns of portfolio over the last 35 years.

Precious metal stocks move much differently than those of the S&P 500. Often when major markets fall, precious metals shine. At the same time, when the S&P 500 performs well, precious metals don’t necessarily fall. Instead of a negative correlation, precious metals are attractive to diversifiers because they have little correlation to the standard fare found in most portfolios. Explore other categories to diversify among which spread risk. Some of these include real estate stocks, high yield bonds, and small company stocks.

Tax Diversification

Some investors do a wonderful job of diversifying investments to shoot themselves in the foot with a lack of tax planning. A person investing only in a 401k plan is going to suffer huge tax consequences when withdrawing retirement dollars. Although the investor received nice tax treatment while saving, withdrawal options are minimal. A retired investor with only a 401k to draw from can either take funds to buy groceries and pay taxes to get the money, or avoid eating. There is no tax relief when funds are removed from this plan.

Individuals should also explore Roth IRA plans, tax-free investments and tax deferred annuities to achieve a well-rounded portfolio designed to create tax benefits while savings and when withdrawing assets.

Before embarking on a diversification plan, write down some goals. These will ensure you’re spreading assets to better achieve goals than simply to avoid having too much money in a single investment. Explore overlap in your current investment strategy, round out your portfolio with new categories that better spread the risk, and align your tax shelters with long range plans. Once you’ve accomplished this, you’ll be not only diversified but also on track to meet your goals.