How many mutual funds do I need to own to be properly diversified?
A lot more than you think.
Sometimes we think about diversification in a very one dimensional sense. Maybe we need to diversify our thinking … about diversification.
First of all diversification is fancy language for not putting all your eggs in one basket. It is the art and science of embracing variety over specificity for the purpose of reducing the risk of significant loss.
It is an ancient practice. Wise King Solomon advised, “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.”
The word diversification has come to be associated almost solely with investments. That’s too bad. The need for diversification is much broader. Here are just few areas in which you need to diversify to reduce significant risks:
Investment diversification. General Motors, Lehman Brothers, WorldCom, Enron, Pacific Gas and Electric, Delphi…all names that in their day stood for solid profits and strong balance sheets. All of them went into bankruptcy. Some emerged in some form; others are gone forever, along with 100% of their investors’ money. Obvious lesson: don’t put all (or even a lot) of your money in one single company’s stock.
Liquidity diversification. This could also be called “the need to spend money” diversification. You just never know when an auto accident, a hospital stay, a leaky roof or a lost college scholarship may call on you to spend money you were not expecting to spend. That’s why we advise clients to keep at least six months spending needs in accessible, liquid form – otherwise known as cash.
Tax diversification. Has someone told you to put all the money you can in a 401K plan? The usual rationale for such advice is that you can defer money from a high income tax bracket to a lower one, when you retire. But who guaranteed you that your taxes will be lower? What if they are higher? I have absolutely no clue where tax rates will be when I retire. That’s why I don’t want to bet the farm on a single tax strategy of deferring my tax obligation until that time. I’m doing some of that – just not all.
Actuarial diversification. Because you don’t know how long you or your spouse will live, the only rational thing to do is to plan on living a very long time. An insurance company or a pension plan does not have that problem. Because they are looking at the average of multiple lives, they can tap into actuarial science and determine the average life expectancy of the group. And since the average life expectancy will (by definition) be shorter than the longest one might expect to live, the cost per person of retirement income is lower.
That’s why annuities and permanent life insurance can be useful tools when skillfully paired with investments in a balanced fashion. Always work with a licensed professional advisor concerning these matters.
No doubt investments are what most of us think when diversification is mentioned. I hope you now see the area that needs the most diversification is your diversification.