- The basics of diversification are commonly known to financial planners and to most every investor. Stemming from the Harry Markowitz paper "Portfolio Selection," which appeared in the 1952 Journal of Finance and brought to widespread notoriety thirty-eight years later in Markowitz’s sharing of the 1990 Nobel Prize in Economics with William Sharpe who had published his work the capital asset pricing model in 1964 as an extension to Markowitz’s work and introduced the notions of systematic and specific risk. The topics of diversification and now, asset allocation are part of most any cocktail party discussion concerning investment strategy.
- Simply, risk may be “diversified away” by incorporating non-correlated assets within a portfolio. Further explained in a 1986 study by Gary Brinson, Randolph Hood, and Gilbert Beebower, Brinson, Hood, and Beebower's study (also known as "Determinants of Portfolio Performance") found that the mix of stocks, bonds, and cash determines how volatile your portfolio will be. The study which compared the actual quarterly total returns of 91 major, actively managed pension funds over the 1974 to 1983 period against the performance of a theoretical sibling fund that held the same average asset allocation (stocks, bonds, cash), but which indexed its investments concluded that asset allocation rather than individual security selection explained 93.6% of the variation in a portfolio's quarterly returns.
- The first dimension is the use of the various asset classes of stocks, bonds and cash in basic diversification. These classes may be further divided by added the international component in equities and bonds.
- The second dimension involves adding the style of investment to the diversification of assets, these are:
- 1) Capitalization- large, medium, small and micro cap equities.
- 2) Style- value, growth and core.
- 3) Sector or industry diversification.
- 4) Fixed income- short, medium and long-term.
- 5) Issuer- high quality corporate, lower rated corporate, U.S. Government issues, government agency issues, and foreign government issues.
- The third dimension is grossly overlooked and involves the treatment of taxation and the impact on estate planning as a consequence of the diversification and choice of assets used in various portfolios.
1) Have a thorough discussion with your financial planner which will entail: income, expenses, assets, family background, work benefits, etc.
2) Consider existing allocation of assets and availability of investment choices within current and future contributions to retirement plans, deferred compensation plans, variable, universal and fixed insurance options, and ESOP plans.
3) Consider use of funds and timing or range of timing for that use.
4) Most importantly have a keen understanding for your prioritization of goals and your comfort level related to investment risk or the risk of not achieving your goals.
5) Match the nature of investments to the type of account and the purpose for which that account is established for:
For qualified money or college funding this is very simple to accomplish.
Obviously qualified retirement funds are generally geared for long-term growth and are established in tax-deferred accounts. Investments to consider would be equities, higher yielding bonds with a lack of sensitivity to taxable distributions or efficiencies, therefore funds that perform very well but involve high portfolio turnover or high capital gain distributions are good candidates for tax-deferred accounts. College funding vehicles within educational vehicles such as 529 plans and Education IRA’s have very similar features but are limited to mutual funds or pre-paid tuition credits in 529 plans.
For non-qualified funds, the goals may be myriad and diverse.
They may include: short-term emergency funds, mid-term accumulation funds for buying a car, primary residence, taking a vacation, home renovation, buying additional real estate, etc. They may be for the supplement of college education, retirement income or established for a family legacy or for charitable causes. These assets may include more tax-efficient investments that bear little or no taxes on a current basis and have a more benign effect on the estate or are able to “step-up” at the death of the owner to effectively minimize income or capital gains taxes. Consider zero-coupon municipal bonds, tax-managed equity funds, 15%-eligible common and preferred stocks, stocks focused on capital appreciation. Life insurance and survivorship life insurance products are also to be considered for their tax efficiency especially within accounts that have been designed for estate sensitivity such as irrevocable life insurance trusts.
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