Diversification is not just about having a portfolio allocated to various asset classes.
There are 3 layers of Investment portfolio diversification.
The first is tax diversification. Next is asset class diversification. Last is diversifying between risk money and safe money. Not having all of your portfolio exposed to risk can be super helpful in navigating down markets and being able to stick with your long-term investment plan.
Let’s get a bit deeper in the 3 layers of Investment Portfolio Diversification:
Tax diversification involves structuring your investments in a way that balances your tax liability. For example, you may have some investments in tax-deferred accounts like 401(k)s and IRAs and others in taxable accounts. This way, you can potentially reduce your overall tax liability and maximize your after-tax returns.
Asset class diversification, involves investing in different asset classes like stocks, bonds, and real estate to reduce overall portfolio risk. By spreading your investments across different asset classes, you can potentially benefit from the performance of each asset class while reducing the risk associated with any one asset class.
Diversifying between risk money and safe money refers to balancing your portfolio between assets with different risk profiles. For example, you may have some investments in stocks and other high-risk assets for potential growth, but also some investments in safer assets like bonds or cash for stability and to limit potential losses. This can help you weather market downturns and maintain your long-term investment plan.
Overall, these three layers of investment portfolio diversification are important considerations when constructing a well-diversified investment portfolio. By balancing tax liabilities, asset classes, and risk profiles, investors can potentially reduce their overall risk and increase their chances of achieving long-term investment success.
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