Variety: We Have it in Our Wardrobes. Why Not Our Finances?
How many of you have had the following conversation with the men in your lives?
The male enters your closet, studies the contents, takes inventory of a few categories, turns to you and says, “Why do you need more than one pair of black shoes?”
You then lovingly explain that different shoes are needed for different times of year, different weather conditions, different types of events, different types of activities, etc.
We understand that silk shoes cannot be worn in wet conditions and that stilettos make picnicking in the park a challenge. I gained most of my understanding of these issues through trial and error, and as my checkbook has expanded, so has my shoe collection. Now I feel that I am prepared for just about any type of event, activity, weather condition, etc. you can throw at me – as are most of the women I know.
We apply the same strategy to our clothing, coats, pocket books, jewelry, sunglasses and swim suits. Are you applying it to your savings and investment portfolio as well?
I often ask clients what “diversification” means to them and their portfolio. Everyone discusses the importance of diversifying around the risk levels of the investments in their portfolios. This is part of the correct answer. The reality is that there are multiple risk factors that should be included in your diversification strategy. Other components of risk include liquidity/timing and taxation.
While preparing your plan, you should consider the specific goal along with the timeline you have to reach the goal. Two extremes are a savings goal for a vacation vs. a savings goal for retirement. When saving for vacation, we know that the money will be needed within a short period of time. So, using savings tools that penalize you for early withdrawals or that have heavy upfront fees would be poor choices. On the other hand, those same penalties are appropriate and perfect incentives for you to leave your retirement savings accounts intact.
The portion of a diversification strategy that addresses taxation is more complicated mostly due to the uncertainty that surrounds the issue. Here are some facts:
1. Believe it or not, we are currently living with some of the lowest income tax rates since the creation of income tax.
2. This year, the tax laws changed and some people paid more taxes than they have in the past.
3. According to a website usdebtclock.org, the US national debt has risen to over $1.6 Trillion. To put this in perspective, that’s over $148,000/tax payer.
At this point, the guessing game begins. No one knows exactly what the future holds for income and investment tax rates. So, I encourage people to prepare themselves for a variety of circumstances.
Changes in tax structure are rarely a concern in the short term but are an important consideration for long term goals such as retirement. The simplest way to diversify against changes in tax structure is to utilize multiple savings vehicles with different tax implications. Some tools allow pre-tax contributions with taxable withdrawals, others are the opposite and still other scenarios exist. The point is to place savings into multiple scenarios so that, during retirement, your desired income can flow from multiple streams, with different tax implications to optimize your tax situation.
The one thing to remember is there is more to diversification than investing in high vs. low risk strategies. Timing and taxation are also considerations.