Investopedia defines diversification as “a risk management technique that mixes a wide variety of investments within a portfolio”. In simpler terms, don’t put all of your eggs in one bucket, right? We’ve heard the old adage countless times not only in regards to investing but also in life. It makes perfect sense. By going all in on a particular strategy, you’ve essentially pinned whatever your end goal is solely on that coming fruition. What happens when your strategy isn’t maximized, or even worse, fails altogether? In some aspects of life, we simply pick things up and start over. But when it comes to financial planning, you aren’t always afforded that luxury. That’s where a bucket approach comes in to play. It’s no longer enough to simply diversify and keep your fingers crossed. It’s time to diversify within diversification.
As I noted in a previous article, The New Normal: Thinking About the Future Through a Different Lens, several factors have become prevalent in today’s financial environment that make traditional diversification dicey at best. Correlations are on the rise, which makes it incredibly difficult to find ways to truly diversify. The point of mixing a wide variety of investments within a portfolio is to find investments that behave differently, as an attempt to reduce risk. However, globalization and central bank intervention across the globe have resulted in growing correlations among even the most traditional investments, especially during times of stress within the markets.
If rising correlations weren’t enough to ponder a new way to diversify, take a look at volatility that exists in today’s markets. Between 1996 and 2015, there were 422 days when the S&P 500 Index had a move of 2% or more. Rewind even further back, and look at the time period from 1956 to 1996. During that 40 year span, there were just 254 days of 2% or more price movements in the index. So in a span of just nine years, this even occurred 1.67 times more than it did over a 40-year time frame.
For the most part, interest rates have been declining for nearly 30 years. Low inflation and monetary policies that are accommodating have pushed yields on the 10-year U.S. Treasury Note to a low of 1.61% in 2012. Consider that in 1981, the yield was over 15%! Although the U.S. Federal Reserve has slowly begun to emerge from a zero interest rate environment, central banks throughout the rest of the world remain extremely accommodating, which could lead to global rates that stay low. As you look back at the historical yield of the 10-year U.S. Treasury note, bonds may not be able to provide adequate income in the low-interest rate environment that we face for the foreseeable future. Here’s another piece to consider. What happens when interest rates actually start to rise? Traditional fixed income investments may suffer losses as rates rise, which diminishes the short-term value of fixed holdings.
Diversify Within Diversification
So how do we avoid some of the risks outlined above? It’s an answer that some may not want to hear, but as I’ve stated many times, there is no “one-size-fits-all” answer. However, I can state that employing a bucket approach can prove to be very effective in diversification. This may mean that you have a totally different plan than the next person in terms of underlying components, but the overall strategy itself is simple. The more buckets you are able to employ, the better chance you have at staving off some of the headwinds that are inevitable in life.
To diversify within diversification, you not only avoid putting all of your eggs in one bucket, but you also create buckets on buckets. In simpler terms, let’s say you have a well-diversified mix of holdings within your 401(k), and after maxing out your contributions, you open a Traditional IRA that holds a well-diversified mix of mutual funds. While the exercise itself is great, you’ve not created another bucket, as both are taxed in the same manner (deferred taxation). Instead of setting up another bucket of funds that will be taxed upon withdrawal in retirement, consider the value of a Roth IRA. Just by setting up a Roth IRA, you’ve created another bucket, as you now have a choice of where you go to withdraw funds in terms of potential tax ramifications, instead of only having a bucket that holds all tax-deferred fund.
While setting up different buckets in terms of the taxation can prove to be extremely beneficial in retirement, you can take this strategy even further. Let’s say you’ve established a Traditional IRA and a Roth IRA, but both hold the same type of underlying investment. You’ve managed to give yourself flexibility in terms of withdrawals, but you’ve not removed any of the potential pitfalls above. This is where it is prudent to have buckets of not only different tax qualifications but also entirely different investments.
The Modern Portfolio Theory was created in an environment that had a limited range of choices, where expected return and risk were based on a mix of stocks and bonds. In those times, an investor seeking to lower risk in their portfolio would simply tilt their portfolio weighting towards more bonds, whereas investors looking for maximum returns would seek out more stock allocations. But as I’ve laid out above, today’s environment forces us to look at the investment landscape differently.
There are ways to create a more diverse portfolio through the addition of alternative investments, which tend to not be correlated with stocks or bonds. A common mistake that I see or hear is when others treat alternative investments as a single asset class. Alternatives cover a wide spectrum of assets and strategies, and should not be looked at as a replacement for a class in your portfolio, but rather a complement to your portfolio.
Investors should always consider alternatives while keeping in mind their goals, objectives, risk tolerance, liquidity needs, and time horizon. Only then can an investor begin to review how alternatives might serve as a complement to their traditional portfolio. Although alternative investments have varying degrees of risk and return, they may be able to contribute to improved overall returns on a portfolio due to their lower correlation to traditional investments.
Buckets on Buckets
As you can see, there are many ways you can prepare for the road ahead. Simply having a Traditional IRA bucket that holds a 60/40 mix of stocks and bonds may not be as prudent of a strategy as it once was. By creating buckets on buckets, you can give yourself the freedom and flexibility to determine when and where you withdraw, as opposed to the financial landscape dictating how you live out your retirement.
Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.
Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.
***Alternative Investment Disclosure: Diversification does not assure a profit or protect against loss in a declining market. Portfolios that have a greater percentage of alternatives may have greater risks, and this additional risk can offset the benefit of diversification. Alternative investment strategies such as leveraging, arbitrage and commodities investing are subject to greater risks and volatility than more traditional investment offerings. Although asset allocation among different asset categories generally limits risk and exposure to any one category, the risk remains that an asset category could perform poorly relative to the other asset categories. Some of those risks include general economic risk, geopolitical risk, commodity-price volatility, counterparty and settlement risk, currency risk, industry concentration risk, leveraging risk, market risk, liquidity risk, real estate investment risk, and sector risk.***