The Diversification Advantage You're Looking For Is Right Here
Estimated reading time: 3 minutes
Owning five pairs of running shoes in five different colors seems like a diversified shoe closet until you need a pair of shoes to wear to a wedding, graduation, or funeral.
At which point, your shoe collection won’t seem so diversified.
The same is true of your investment portfolio. Owning equities in five different large-cap tech companies isn’t real diversification.
Diversification is vital in a retirement savings strategy. Let’s talk about how you can build it.
Diversified Allocation Plan Basics
On the surface, diversification is about owning assets in a variety of classes; equities and bonds being two of the most common classes.
After diversifying assets by class, they should be further broken down by sector. You might consider owning stocks and bonds in a variety of sectors: energy, finance, technology, and consumer packaged goods, for example.
For many investors, owning shares in mutual funds is an efficient way to achieve these degrees of diversification.
Contemplating diversification at a deep level requires thinking about how your assets will react in relation to one another and to the broad spectrum of current events.
For instance, the rise and fall of the U.S. stock market tends to move large and small-cap shares up or down at the same time. You can protect yourself against this kind of movement by owning equities in international companies.
Inflation should also be considered in an allocation strategy. Gold has a long history as a hedge against inflation. It also has a track record of moving in opposition to the stock market: when markets are down, gold prices rise and vice versa.
(Read more about correlation.)
Your goal is to own a variety of assets, so that when one asset class is on the decline and another is on the rise, you can react appropriately and protect your retirement nest egg.
The “Yes, And” Approach to Diversification
An allocation plan is not a zero-sum game. It’s an additive game.
As you add asset classes to your allocation plan you are mitigating risk, hedging against inflation, and improving your chances for higher returns.
Here’s a look at what three different asset classes add:
- Private equity offers potentially higher returns than more traditional large- or even small-cap equities. However, these assets are less liquid and you may have a failure or two before succeeding.
- Real estate, while illiquid, has revenue generation. It removes you from the stock and bond markets and is an asset class many investors are already familiar with.
- Precious metals are a store of value in and of themselves. They are widely acknowledged as a hedge against inflation. As precious metals prices typically run counter to the stock market, your return might be lower, but so is your risk.
The most important “add” to diversification is being in a stronger position during a market downturn.
Potential Alternative Investments
The world of alternative investments is infinite. Here are some examples of what you can invest in:
- Private equity
- Private placements
- Limited Liability company (LLC)
- Limited partnership (LP)
- Joint ventures
- Venture capital
- Developed or undeveloped land
- Single-family homes
- Office building
- Shopping center
- Parking garage
- Retirement home
- Industrial building
- Mobile home park
- Mortgage notes
- Performing or non-performing notes
- Micro loans
- Oil and gas investments
- Hedge funds
- Precious metals such as gold, silver, palladium or platinum
- and more!
The IRS identifies a few investments that are prohibited. You can find the list in IRS Publications 590-A and 590-B.
Advantages to Holding Your Alternative Investments in a Self-Directed IRA
Here are a few reasons why a Self-Directed IRA is the best way to tap the full potential of the investment universe:
Your capital gains are tax-deferred in a traditional IRA and potentially tax-free in a Roth IRA.
Many alternative assets have a longer hold period or are less liquid, making them good choices for an investment vehicle with a long-term investment horizon.
Having an IRA custodial relationship demonstrates to companies seeking investors that you have a funded account and are ready to invest.
Diversifying your portfolio doesn’t have to be challenging. A Self-Directed IRA gives you unmatched power to control your retirement investments. Any investment allowed by law can be held in your Self-Directed IRA.
Download our Self-Directed IRA Basics Guide now to learn more.