Most investors are at least somewhat familiar with the concept of diversification, even if they don’t give it much thought or put the notion into practice within their own accounts. And while some investment commentators might occasionally proclaim that the idea of diversification is outdated, most experts recognize its importance even today.
The basic theory of investment portfolio diversification holds that by investing in more than just a single asset, the investor can reduce their risk of losing a significant portion of their portfolio if that one asset were to decline in value. Diversification is one reason that mutual funds and exchange traded funds are a more popular choice than individual stocks for many investors.
Diversification can become particularly important with an account such as a self-directed IRA, because there are so many more investment choices available to self-directed IRA account holders and those who have their retirement funds with a traditional custodian. Here are three key diversification principles to keep in mind.
Diversify Not Just For Your Age, But For Your Investing Profile. Discussions of diversification often start with your age. The argument is something along the lines of taking a more aggressive diversification stance younger in life so that you have the best opportunity to maximize your nest egg, while keeping in mind that you’ll have more time before retirement to recoup any losses that may result from such a stance.
But you also need to take into account your individual investing personality. How risk averse are you, generally speaking? Does the prospect of losing money, even if it comes with the opportunity to gain more, keep you up at night? These types of questions should give you some idea of your starting approach for retirement account diversification.
Don’t Over-Diversify. By this we simply mean that while diversification should be an important principle to incorporate into your retirement investment decisions, it shouldn’t be the sole driver of your actions.
For example, if you have a large investment in your self-directed IRA that has performed very well and now represents a significant part of your portfolio, your diversification principles may suggest that you sell the investment in order to maintain a “proper” investment mix. However, if you still have significant confidence in that investment, you may not wish to get rid of that quite yet.
Furthermore, if you’re faced with significant transaction costs in connection with trying to meet some diversification goal (such as selling real estate holdings or private investments), then this may impact your decision.
Different Considerations During Retirement. How will you be using your self-directed IRA during retirement? Will it be your principal source of retirement income, or do you have other adequate sources of income (such as employer-sponsored 401(k) plans, employer pensions, and Social Security) and want to use your self-directed IRA as more of an investment and/or estate planning tool?
In addition, if you plan to use your self-directed IRA to make pre-retirement withdrawals in order to help your children or grandchildren with educational expenses, medical expenses or even down payment assistance for their first homes, then you’ll want to be sure that you have appropriate liquid assets available in order to withdraw on the appropriate schedule.