In 1952 a young PhD student named Harry Markowitz wrote a paper 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 effectively diversify their investments, something which was not well understood at the time. Markowitz explained, for example, that the number of stocks you hold is far less important than the number of types of stocks you own. For example, a portfolio of sixty stocks might appear to be diversified, but if all sixty are technology stocks, then there is still quite a bit of risk. Today this might seem like common sense, but at the time it was a major revelation.
Markowitz ultimately won a Nobel Prize for his work, and there’s no question that it was brilliant. But, that was more than sixty years ago. Yes, Markowitz’s original conclusions are still valid, but today there is much more you can do to manage risk in your financial life. As you start the new year, here are six ideas to help you think more comprehensively about using diversification to manage risk:
Diversify your tax rates – If you’re saving money through a retirement account like a 401(k) or an IRA, you’re already doing this, choosing to pay taxes at future rates rather than today’s. This is 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 529 savings accounts for K-12 expenses, and some states even offer deductions on 529 contributions. There is also the so-called “backdoor” Roth IRA, which may allow you to contribute to a Roth regardless of your income level. There are Health Savings Accounts (HSAs), which are triple-tax-advantaged, if you are eligible. And, of course, there are trust structures, which you can use to alleviate the burden of estate taxes. These are just examples. With a little bit of research, you may be surprised to learn what strategies are available to you.
Diversify the types of investments you own – In Markowitz’s time, the investment world was much simpler, consisting primarily of stocks, bonds and a handful of mutual funds. Today, you have a much broader set of choices, and at remarkably lower cost. But, you also want to be careful. Exchange-traded funds (ETFs), for example, have become extremely popular since they were invented in 1993, but they have also exhibited some weaknesses. In the “Flash Crash” of May 2010, for example, the prices of many ETFs briefly fell to a penny per share for no explicable reason. They did rebound, but with that history in mind, I always recommend diversifying the types of investments you hold. Don’t own just ETFs or just mutual funds; instead, own a broad enough mix to protect yourself against the sorts of extreme and unexpected events that occur from time to time.
Diversify your financial relationships – If you’re from New York, you may remember the blackout of 2003. Among other effects, ATM machines and credit 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 does have vulnerabilities. Increasingly, these vulnerabilities include the risks posed by hackers. For that reason, I don’t think it’s unreasonable to maintain accounts at more than one financial institution. For example, arrange things so that your bank, credit card and investment accounts are with three different institutions. I don’t mean to be a fear-monger, and I don’t have any specific risk in mind, but in today’s environment, this seems like a reasonable precaution available at essentially no cost.
Diversify the timing of your investments – Many market experts (including Yale’s Bob Shiller, who accurately predicted past crashes), believe the U.S. stock market is overpriced, and clients often ask me if it is unwise to invest at this time. The fact is, however, that markets are not rational, and no one can predict whether the market will see a decline any time soon, or if it will first continue to rise. For that reason, if you have excess cash, what I recommend is to invest it over time, on a fixed schedule — for example, 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.
Diversify the timing of your withdrawals – If you are in retirement and taking required distributions from your IRA, you may wonder what the best strategy is for making those withdrawals. In my view, for the same reasons I cited above, the ideal approach is to have your custodian issue your distributions in equal monthly installments.
Diversify your student loans – If you have student loans, you’ve probably received refinancing offers from private lenders. Their pitches sound enticing: lower your rate and consolidate your loans into one easy payment. But, what they don’t advertise is the fact that Federal loans offer a number of borrower protections, flexible payment options and even outright loan forgiveness that private lenders do not. As you weigh the trade-offs of refinancing, I would again apply the principle of diversification. You might not want to go all-in with a private lender, but you also shouldn’t have to live with all of your loans at the steep 6.8% rate typical on most Federal loans.
Ben Franklin once wrote that “an ounce of prevention is worth a pound of cure.” When it comes to your finances, I couldn’t agree more.