I’ve repeatedly emphasized that in the interest of diversification we must strive to hold as many pillars as possible. There are two ways in which we may fail to achieve diversification: when we hold one large pillar which dwarfs others, or when we have multiple pillars, but they all invest in the same overlapping assets.
One Large Pillar
The single-large-pillar scenario typically arises for doctors who stay with one employer and end up retiring with one large retirement account (e.g., a 403(b) account), or those who own a medical practice. In either case the doctor has one large pillar which may be worth several million dollars.
The danger when you only have one major pillar is that if it’s damaged, for whatever reason, your entire financial foundation may be devastated. The basic defense against a single vulnerable pillar is to have several smaller, diverse pillars.
Individual pillars are not just susceptible to economic forces. They can also be undermined by legislative changes. There was recently a legislative effort to cap the cumulative amount of contributions made into retirement accounts. While the effort was defeated there is no telling which pillars may be undermined by future legislation. The most recent tax overhaul took away traditional deductions, surprising and dismaying many homeowners in states with high property taxes.
As baby boomers retire in large numbers, and our public safety nets get stretched to the breaking point, governments will scramble to find new sources of funding. As a result, some of the tools we rely on for retirement, including tax breaks, may come under fire. Since we don’t know which assets may be most disadvantaged in future, our best move is to diversify our holdings across as many assets or pillars as possible.
Multiple Overlapping Pillars
Some investors own multiple pillars, including 401(k), 403(b), 529s, or IRAs. But the holdings in these accounts are invested in very similar assets.
For example, the standard investment recommended by all gurus and advisors is exposure to stocks of large American corporations. This asset class is often referred to as the Large Cap asset class. The most common way to gain that exposure is the purchase of an index fund tracking the S&P 500 index. Many of us have this particular exposure in every investment account or pillar we own.
We may have similar exposures in each account to some of the other popular asset classes, such as Mid Cap stocks and Investment Grade Domestic Bonds. The more similar these holdings, the less diversification we get across accounts. If we’re already very well-diversified within each account, then we are also by construction well-diversified across accounts. But if we have similar holdings across accounts and all accounts have some diversification flaw (for example, they under-allocate to international stocks), then we have less overall diversification than we think.
Give conscious thought to your investment choices and ensure they are truly diverse!