A YOUNG GRADUATE student named Harry Markowitz wrote a paper in 1952 that sought to prove, mathematically, the old maxim “don’t put all your eggs in one basket.” Through his work, Markowitz taught investors how to diversify their investments effectively, something that was not well understood at the time.
For instance, he explained that the number of stocks you hold is far less important than the number of types of stocks you own. A portfolio of 60 stocks might appear to be diversified. But if all 60 are technology stocks, there is still quite a bit of risk. Today, this might seem like commonsense, but at the time it was a major revelation.
Markowitz ultimately won a Nobel Prize for his work, and there’s no question it was brilliant. Today, however, there’s even more you can do to manage risk in your financial life. Here are five ideas to help you think more comprehensively about diversification:
1. Diversify your tax rates. If you’re saving money through a traditional retirement account, like a 401(k) or an IRA, you’re already doing this, by choosing to pay taxes at future rates rather than today’s. That’s a great move, but don’t stop there. There are other accounts which can also help you diversify your tax exposure.
For example, under the new tax laws, you can now use the tax-free growth offered by 529 savings accounts to pay K-12 expenses. Some states even offer an income-tax deduction for 529 contributions.
Tax-free growth is also available from Roth IRAs and 401(k)s, thus providing a hedge against higher future tax rates. Don’t have a Roth 401(k) at work and don’t qualify for a Roth IRA? Check out the “backdoor” Roth IRA, which may allow you to contribute to a Roth regardless of your income level. And don’t forget Health Savings Accounts, which are triple-tax-advantaged for those who are eligible.
2. Diversify your investment products. In Markowitz’s time, the investment world was much simpler, consisting primarily of stocks, bonds and a modest number of mutual funds. Today, you can choose from a much broader array of investments, some with remarkably low costs.
But you also need to be careful. Exchange-traded funds, for example, have become extremely popular since they were invented in 1993, but they have also exhibited weaknesses. In the “Flash Crash” of May 2010, the prices of many ETFs briefly fell to a penny per share for no explicable reason. With that history in mind, I recommend diversifying the investment products you hold. Don’t own just ETFs or just mutual funds. Instead, own a broad enough mix to protect yourself against the sort of extreme and unexpected events that occur from time to time.
3. Diversify your financial relationships. If you’re from New York, you may remember the blackout of 2003. Among other effects, ATM machines and credit card networks went dark, making it difficult to buy food. The root cause turned out to be a malfunction at an electric utility in Ohio.
For many, this was a reminder that our financial system has vulnerabilities. Today, that includes the risk posed by hackers. As self-defense, I don’t think it’s unreasonable to maintain accounts at more than one financial firm. You might arrange things so that your bank account, credit cards and investment accounts are with different institutions.
4. Diversify the timing of your purchases. Clients often ask me if it’s wise to invest in stocks right now. Unfortunately, no one can predict whether the market will see a decline any time soon—or whether it will continue to rise.
Got excess cash? I recommend investing it on a fixed schedule, such as one-tenth each month for ten months. If the market keeps going higher, you will be glad you didn’t wait. And if the market goes down, you’ll be happy you didn’t invest it all at once.
5. Diversify the timing of your sales. If you are in retirement and taking required distributions from your IRA, you may wonder what the best strategy is for making those withdrawals. I apply the same rationale to sales as I do to purchases. Because we don’t know how markets will perform in the short-term, I would ask your IRA custodian to issue your annual distribution in equal monthly installments over the course of the year.
Adam M. Grossman’s previous articles include About That 22%, More for Your Money and Your Loss, Their Gain. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.