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What is Diversification

by Jason on August 29, 2011

What is diversification?

Merriam Webster defines it as giving variety to something.

Variety is good.

It’s good in life, in business, and particularly with our savings.

The idea of diversifying has been around a long time.

With today’s market volatility, it’s increasingly important to answer the question – what is diversification – through the use of four different lenses.

An acronym is helpful to understand the lens:

What is Diversification from the P.I.T.T.?

1. Product

What is diversification of products?

Diversification of products simply means that you utilize a variety of investment vehicles.

Some products offer guaranteed rates, others offer guaranteed income (with fees of course).

Other products offer downside protection.

Products are designed with different functions.  It’s important to have a variety of products when it comes to our retirement savings.

2. Investment

What is diversification of investments?

This means you diversify across asset classes with stocks, bonds, and alternative investments.

You also want to look at diversifying within those asset classes both by different types of stocks, but also diversifying with numbers of stocks.

An example of diversifying within asset classes would be choosing defensive positions during difficult times like dividend-paying stocks, consumer staples, or precious metals.

This is a key to adding additional returns during difficult markets.

3. Time

How do you diversify through a time lens?

This means you have short, medium, and long-term investments.

If you have an emergency fund and something happens to your job, you won’t have to take an early IRA withdrawal.

You will be able to weather that storm because you’ll have short-term investments.

Some products with guarantees may have time schedules that you must keep to avoid charges.

Having shorter term investment money is a wise diversification move.

4. Tax

What is diversification for taxes?

Diversification from a tax standpoint means that you work at balancing tax deferred, “taxed now”, and tax-free accounts.

In other words you intentionally build tax-deferred assets like IRAs and  401ks.

You also think about building regular brokerage accounts or what would be called non-qualified money.

And lastly, you think about building tax free money with a Roth IRA or Roth 401k.

Following these guidelines does not insure investor success, however, diversifying your savings from these standpoints can help reduce risk and generate more consistent returns over the long run.

As always, be sure to consult with a tax advisor when making tax decisions.

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Readers, post your comments:

  • What is diversification to you?
  • Do you diversify from the PITT?
  • What other diversification have you done (like income?)

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