We’ve all heard not to put all our eggs in one basket when it comes to investing. Most of us would agree that sure, it’s good to have diversification but it seems like this concept of diversification has become misunderstood.
When someone says to me “I don’t want all my eggs in one basket,” they are saying they want to spread their risks out. An investor that invests only in the US stock market is putting all of his eggs in one basket. An investor who invests only in bonds is putting all of her eggs in one basket. They aren’t diversifying their portfolio and as a result are taking on risk.
Some investors make a mistake and think they are diversifying their investments, but in reality the opposite is more likely. Here are a few examples to consider:
Common Problems of Improper “Diversification”
- Multitude of Accounts: If an investor has a lot of different assets in different accounts it may be hard to track them all. They receive multiple statements in the mail and have to navigate different custodians when they need to make changes. It could cause confusion particularly around tax time. It becomes an administrative issue.
- Tax Impact: Having multiple accounts may cloud one’s view of tax consequences. They could be dealing with gains and losses in different accounts. If not coordinated, an investor could be paying more in taxes than needed. We refer to this as a tax loss harvesting strategy, where we sell investments at a loss to offset ones we’ve sold for a gain.
- Similar Underlying Investments: A common situation occurs when an investor has multiple mutual funds from different fund companies, thinking they are diversified. But in reality, those funds may own the same or similar underlying investments. The investor may be putting all their eggs in one basket and not even realize it. Similarly, we see investors who own utility stocks and income oriented mutual funds. When we dig into the holdings of the mutual fund, we aren’t surprised to see it comprised of utility stocks, as well. Again, the investor is putting a lot of their eggs in one basket.
- IRA RMD: Required Minimum Distribution (RMD) can be a massive headache if you haven’t consolidated your IRAs or 401(k)s. Missing an RMD (or not taking it out) can result in a 50% penalty.
Get Rid of Unintended Risks
As we’ve seen, the myth of diversifying assets can be misleading. It’s important to understand the true implication of diversification. Knowing how to invest properly by getting rid of unintended risks and allocating your retirement portfolio can give investors peace of mind and confidence in this present economy.