How do I diversify my investments now?
Figuring out how to maximize your savings can be a real challenge. There’s no single formula or no one right way to create a diversified portfolio. But while there are many different paths the goal of financial success, Tony’s concentrated what he learned from talking with 50 of the world’s top investors into four core principles. Think of it as your investment foundation.
What do you need to do to make the most of your savings? These four principles:
- Protect the principal as much as possible
- Take only asymmetric risks
- Be tax efficient
- Be well-diversified
Core principle #1: Do not lose money
How do you do that? You structure your portfolio so that it can stay above water and minimize losses, even when the market dips or when you’re wrong. And you model it on some of the smartest, savviest investors in the world that have proven track records of success. These people are obsessed with not losing money. Completely obsessed.
So how do you not lose money? The secret here is asset allocation. Think of separating your funds into two distinct investment buckets, each with their own levels of risk and reward.
Core principle #2: Asymmetric risk & reward
We have been programmed to think that the only way for us to grow our wealth involves taking huge risks. That in order to win big, we have to risk losing it all. But it turns out that the top investors follow a different script and take asymmetric risks. Asymmetrical risk reward means that you want to take the least amount of risk possible for the highest level of upside. That’s how you win the game. If you do that, you’ll win long term even if you’re wrong a lot of the time.
One way to bring asymmetric risk and reward into your investments is to use the 5-to-1 rule. The strategy here is relatively straightforward. The 5-to-1 rule means that for every dollar you risk, you have the potential to make five. What this ratio does is it allows you to have a hit rate of 20%. You can be wrong 4 out of 5 times, but as long as you are right that fifth time, you will break even. So even if you’re wrong 80% of the time, you can still come out on top. You just have to be right once.
Another way to incorporate asymmetric risk is understanding investment seasons. Buy when everyone else is desperate to sell; it’s when you find the best bargains. Again, savvy, long-term investors know that seasons always change. What might look like a lost cause now can be acquired for a fraction of the cost that it’s ultimately worth. And at some point, that stock is bound to go back up. The general rule of thumb is that everything returns to the mean. So take advantage of stocks on the decline to build diverse investments. Remember, no matter how cold the winter, there’s a springtime ahead.
It’s all about finding ways to take small risks for big rewards. Swinging for the fences with no downside protection is a recipe for disaster. Learn how to incorporate asymmetric risk and reward into your diversified portfolio and not only will you adhere to the #1 rule of not losing money, you will be well on your way to creating a viable path towards financial freedom.
Core principle #3: Tax efficiency
When it comes to our investments, we have been taught to focus on returns. But it’s not what you earn that matters, it’s what you keep. Grappling with taxes might seem harder than creating a diversified portfolio, but if your portfolio isn’t tax efficient, then you may not be keeping as much as you should be.
As an investor, there are three critical taxes that you must concern yourself with.
- Ordinary income tax. This can be a big one. If you’re a high-income earner, your combined federal and state income taxes are likely nearing or exceeding 50%.
- Long-term capital gains. If you hold your investment for longer than one year before you sell, then you will pay a long-term capital gains tax, which rings in at 20%.
- Short-term capital gains. If you sell your investment before holding it for a minimum of one year, you will find yourself subject to the short-term capital gains tax. And right now, the rates are currently the same as ordinary income taxes.
Between these three taxes, you can only imagine how much you could be paying Uncle Sam. And if you understand the power of compounding, then you realize how a 50% tax bite as opposed to a 20% tax bite can mean the difference between achieving your financial goals a decade early or never achieving them at all.
So how do you structure your portfolio to help reduce your tax bill and keep more of your earnings so you can compound your investments?
- Defer taxes. Whenever possible, you must invest in ways that allow you to defer your taxes. Whether you invest in a 401(k), an IRA, an annuity or a defined benefit plan, deferring taxes means you can compound tax-free and pay tax only at the time you sell the investment.
- Avoid short-term capital gains. If you do choose to sell any investment held outside of a tax-deferred account, such as an IRA, make sure, if at all possible, you hold it for at least one year and one day in order to qualify for the long-term capital gains rate.
- Be aware of mutual funds. Mutual funds provide a certain level of portfolio diversification that is attractive to investors. But did you know that the vast majority of mutual funds do not hold on to their investments for an entire year? And you know what that means? Unless you are holding all of your mutual funds inside your 401(k), you’re typically paying ordinary income taxes on any gains. This means you could paying as much as 35%, 45% or even 50% in income tax, which is taking a devastating hit on your compounding ability.
- Consider index funds. Index funds do not constantly trade individual companies; instead, they typically hold a fixed basket of companies that charges only if the index that the fund tracks changes, which is actually quite rare. This means you get to invest in an index for the long run, which helps you avoid getting hit by taxes each year. Instead, you are deferring the taxes, since you haven’t sold anything, and your money can stay in the fund and compound without the tax “drag” on your returns.
Consult a fiduciary or a tax strategist to help you better understand all the ways you can maximize the compounding process and create more net growth in your Freedom Fund. Remember, tax efficiency equals fast financial freedom, and could save you years, or even decades.
Core principle #4: Diversify! Diversify! Diversify!
Knowing where to park your money and how to divide it up is the single most important skill of a successful investor. Effective diversification not only reduces your risk, it also offers you the opportunity to maximize your returns. A diversified portfolio is a strong portfolio.
Wait, didn’t we already diversify between the Security Bucket and the Risk Bucket in principle #2? Yes! Now it’s time to take it one step further. Now you must diversify within those buckets so that you can structure a diversified portfolio for all seasons. If you keep all your assets in the same class you’re not setting yourself up for success.
How do you do that? Here are the 4 ways you must diversify:
- Diversify between assets within different classes (real estate, stocks, bonds, commodities, private equity)
- Diversify your holdings within asset classes (avoid concentrating putting all of your money into one stock or bond; you must diversify even within your asset classes)
- Diversify globally (different markets, countries, currencies)
- Diversify timelines (dollar-cost averaging, maturity date)
By allocating your money to such a diverse range of assets, you will be able to set yourself apart from 99% of all investors. And the best part? It won’t cost you a dime. Because spreading your money across diverse investments decreases your risk, increases your upside returns over time and does not cost you anything.
By allocating your money to such a diverse range of assets, you will be able to set yourself apart from 99% of all investors. And the best part? A diversified portfolio won’t cost you a dime. Because spreading your money across different investments decreases your risk, increases your upside returns over time and does not cost you anything.
Want to learn more about how to harness the power of the Core 4?
Get all the details in Tony Robbins’ Unshakeable: Your Financial Freedom Playbook, the bestseller that covers how to diversify your assets, make smart investing decisions and master your personal finances today.
Legal Disclosure: Tony Robbins is the Chief of Investor Psychology at Creative Planning, Inc., an SEC Registered Investment Advisor (RIA) with wealth managers serving all 50 states. Mr. Robbins receives compensation for serving in this capacity based on increased business derived by Creative Planning from his services. Accordingly, Mr. Robbins has a financial incentive to refer investors to Creative Planning.