If you have read anything about retirement savings, you have likely heard that you need to diversify your investments. The general recommendation is the same as the old saying: “Don’t put all of your eggs in one basket.”
But what does diversification really mean? Does diversification only involve stocks? How do you diversify in a way that makes sense for you? What steps can you take to diversify properly?
What Is Diversification?
In general, diversification means that you should have a variety of investments. Diversification decreases your overall risk. If you only invest in one type of asset, your entire retirement savings decrease when that asset’s value decreases.
By diversifying properly, you can avoid a situation where every asset’s value drops at the same time. Instead, some investments may decline in value while other assets increase in value.
Essentially, the more you diversify, the safer your overall portfolio is. However, diversification means more than just holding a variety of stocks; it should extend to asset classes as a whole as well.
Many people make the mistake of assuming that if they own an S&P 500 index fund, they are diversified. They think because they own 500 different stocks, they are properly diversified. However, holding all of these stocks does not combat a situation where the entire market takes a turn for the worst.
You might have a diversified stock portfolio but not a diversified portfolio overall. There is a significant difference between the two concepts. Having other investment options apart from stocks is essential.
For example, you might want to hold stocks, bonds, commodities, and a variety of other investments to have true diversification in your IRA, solo 401k, or whatever retirement vehicle you utilize.
Understanding Diversification: Correlation Measures
The term “correlation” is generally whether two investments tend to move in the same direction at the same time. Consider a simplistic example. The sales of snow shovels are correlated with the sale of hats and mittens.
These are correlated because demand is likely higher when it is cold and snows. These two have a positive correlation because they both increase together.
A negative correlation occurs when one investment goes up while the other goes down. The sale of snow shovels and sunscreen likely has a negative correlation, for example.
Non-correlated assets are assets that have no discernable connection at all. There doesn’t seem to be either a positive or negative correlation between the two assets.
When it comes to investments, you want a variety of investments that have both non-correlated assets and negatively correlated assets. Negatively correlated assets offset one another while non-correlated assets are entirely independent of one another.
Low correlation generally is the ultimate goal of diversification. Correlation changes over time, so you likely need to adjust your investments periodically to account for these changes.
How To Diversify Your Retirement Accounts
Most retirement plans will include the same types of investments, including stocks and bonds. However, if you want to diversify further, you might want to consider including alternative investments as well.
1. Bonds
One rule of thumb for bonds is that your percentage of bonds should be about the same as your age. For example, if you are 35 years old, roughly 35% of your whole investment portfolio should be bonded.
That percentage then increases as you get older. Bonds are considered one of the safest investments you can have, which means that using this practice will ensure that your portfolio becomes less risky as you get older.
Many brokers who offer traditional 401(k)s (including a solo 401k) and IRAs have built-in bond options. That way, you can adjust how much of your total holdings are bonds directly through that account.
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2. Stocks
Perhaps the best way to diversify your stock holdings is to hold an index fund. An index fund provides immediate stock diversification. By making one purchase into an index fund, you get a wide variety of stocks. You can, for example, purchase the S&P 500 or the Nasdaq-100 to be exposed to 500 or 100 different companies, respectively.
You can also diversify yourself by purchasing a number of different stocks in various industries. Diversifying on your own is harder, but it can certainly be done.
3. International Stocks
International stock is a stock sold in the United States for a company based in another country. International stocks are riskier than many options in the United States, which means that they often have higher growth potential.
Depending on your age and risk tolerance, 10% to 25% of your portfolio in international stocks is a good rule of thumb.
4. Alternative Investments
Many alternative investments do not have any correlation to the stock or bond market. While some alternative investments can be very risky, that risk can also come with higher returns if you choose the right investment.
Real estate, for example, is a relatively common alternative investment. Real estate values have often risen when stock values fall, so it can be a good negatively correlated investment option. Real estate has also traditionally been a hedge against inflation. Cryptocurrencies, likewise, are touted as a hedge against inflation.
The portion of your portfolio that includes alternative investments is ultimately up to you and your individual risk tolerance. According to some experts, alternative asset allocation between roughly 7% and 12% might make sense, depending on your retirement date and goals.
Of course, the type of alternative investment you choose as part of your retirement plan is up to you. Just be sure that you have a broker or another account manager willing to house your alternative investments as part of your retirement plan. These plans are generally referred to as “self-directed” plans, including solo 401(k)s and IRAs.
Getting Diversification Right
Ensuring that you have properly diversified can be a challenge. However, if you make efforts to have a variety of investments in your portfolio, you are likely well on your way to adequate diversification.
Keep in mind that you have far more options than just stocks and bonds—international investments and alternative investments can be a great way to diversify.
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