Can I diversify a traditional IRA? Is it necessary to diversify your retirement investment portfolio? Is it that important anyway? Are there any do’s and don’ts that you should consider as you diversify your IRA? If these are some of the questions that have been bugging your mind, then you are in the right place because we shall be addressing them at length in today’s article. Read on to get all the answers you need.
Can I Diversify a Traditional IRA? What is diversification?
Diversification is a technique that reduces the risk borne by an investor, through the allocation of investments among different financial instruments, industries, as well as other categories. The main purpose of diversification is to maximize the return of a given investment portfolio, by investing in different areas that should each react differently to the changes occurring in the market.
Most investment professionals today agree that, as much as it doesn’t guarantee the prevention of loss, diversification is one of the most important components of achieving long-range financial goals, while still minimizing risk.
Asset allocation has been such an interesting and proven investment strategy for such a long time now. It entails choosing the right assets for your retirement investment account with the hope that their value will jointly appreciate, even with there being some assets whose value is decreasing due to forces of the market.
As an investor, you can choose from a wide variety of retirement plans, though you should know that not all of them will give you the virtue of diversification. In most cases, as you will realize, only a self-directed IRA will give you the best diversification capability.
For traditional IRAs, investors can only allocate the following assets:
- Mutual funds
- Unit investment trusts
- Exchange-traded funds
- Index Funds
- Real estate (not allowed by most traditional IRA plan sponsors)
It is possible to achieve diversification for your traditional IRA by allocating different financial instruments to your retirement investment portfolio. You can decide, for instance, to about 20% to a financial instrument in all the above-listed categories. If you do not have the time to choose the stocks, bonds, and mutual funds individually, you can simply pick an index fund. Index funds essentially comprise several stocks selected from different industries, which you can invest in as you hope to maximize the returns from each sector.
Why is it important to diversify your investment?
While many investors know the essence of diversification, not all of them know how to correctly achieve retirement portfolio diversity correctly. This generally stems from a lack of understanding about what diversification is all about.
As we have already seen, diversification is all about risk mitigation, through the combination of a wide variety of investments within a given portfolio, that have different correlation aspects (or simply do not move in the same direction). This way, when one investment falls, the other one rises. This kind of movement eventually balances out a portfolio’s volatility over time and offers more stable and predictable returns.
Diversification heavily relies on the non-correlation of assets. This means that when your stock prices are not performing well, your ETFs are on the rise. This tends to mitigate the downside of your portfolio, ensuring that you do not end up losing your investment capital in the event of an economic downturn.
Correlation of asset classes
Generally, there’s usually some correlation between assets from the same asset classes. If you look at the prices of bonds and stocks, for instance, you’ll realize that they are correlated. This means that while you may achieve diversification across your financial instruments, your retirement investment portfolio is not well-diversified.
The best approach to diversification is one in which you have invested in assets from different asset classes. There’s usually little (and in some cases negative) correlation between assets of different classes.
You can, therefore, only achieve this through opening a self-directed IRA, that gives you the freedom to invest in a wide variety of assets, including:
- Real estate
- Undeveloped raw land
- Promissory notes
- Tax lien certificates
- Water rights
- LLC membership interest
- Mineral rights, oil, and gas
- Gold, silver, platinum, and palladium
The wrong way to diversify your retirement investment portfolio
One common misconception amongst investors is that they can achieve diversification by owning many different stocks or even owning a couple of mutual funds.
There’s, unfortunately, such a tremendous overlay of assets from the same class. An investor may therefore hold different mutual funds, and end up losing their retirement investment capital when an adverse market event occurs.
Also, by purchasing funds, you may end up exposing yourself to the same risks. Say fund A has Amazon securities, and fund B has Apple securities. These securities are from the same sector, and therefore present the same type of risk.
Why you may need to roll over your traditional IRA to diversify your retirement investment portfolio
Investors who create self-directed retirement plans that is overseen by a passive custodian usually have the ability to invest in different asset categories. You can, for instance, hold different stocks and bonds, but also mitigate your risks with alternative investments like physical precious metals (gold and silver), real estate, and private equity. This essentially gives you the best chance of achieving retirement investment portfolio diversity.
N.B: Before opening a self-directed account with any financial institution, inquire about the asset classes that are allowed, so that you do not end up opening an account that will not help you achieve your diversification objectives.
If you are not in a position to open a self-directed account (though it is highly recommended that you do so), you can follow these tips:
Invest in different sectors
Instead of purchasing several funds (as you would if you were trying to diversify your traditional IRA), you can diversify into investments like precious metals, tax liens, and real estate.
Avoid banks and financial institutions
If you want true control over your assets, so that you can allocate them at will, then you should stay away from retirement plans offered by banks. Most of them will limit the number of assets you can invest in, thus denying you the chance to achieve true diversification.
That will be all for this article, in which I was responding to the question, “Can I diversify a traditional IRA?”. I hope you found it resourceful, and that you now have the confidence to act make the right decision as far as diversification is concerned. If you have any questions about this article, drop it in the comments section so that I can respond to it ASAP.
I wish you well,
Eric, Investor and Team Member at Gold Retired!