The benefits of diversification in estate planning

All investments come with some element of risk. Equities, commonly known as stocks, expose you to the risk of market volatility and loss of principal. Bonds may offer more stable performance, but are exposed to the risk of non-payment or default. Real estate can be costly to hold yet still decline in value, at least in the medium to short term.

Diversification across different asset classes, and even alternative investments, can help investors mitigate these risks by spreading out portfolio exposures to different risks. That’s why diversification is one of the keys for successful long-term financial planning. This article can help you better understand:

• Different diversification strategies to use

• The importance of diversifying trust assets

• The pros and cons of diversification

• Diversification considerations for estate planning

The main types of diversification strategies

Broadly speaking, the goal of investment portfolio diversification is to allow for growth opportunities while limiting the risks of capital losses and value erosion due to inflation. There are three basic ways to diversify investments: across different asset classes, within a single asset class, and by financial institution or custodian.

1. Asset class diversification

Simply put, asset class diversification is about “hedging your bets” by investing your portfolio in multiple types of investments, such as stocks, bonds, cash and alternative investments. Why? Different asset classes often react differently to economic events – for example, gold prices tend to rise in periods of economic uncertainty, while consumer stocks may show declines. This can reduce portfolio sensitivity to market volatility and financial risks, helping to balance losses and stabilize a portfolio over time, a key objective of long-term estate planning. Asset class options generally include:

• Equities: Buying stocks, or shares of ownership in specific companies, or mutual funds and exchange-traded funds (ETFs) which can offer diversified portfolios of stocks. Equity investments may provide superior returns over the long-term, but may experience higher price fluctuations and risk of principal loss over the short-term.

• Bonds: Bonds allow you to lend money to a company or government entity for a set length of time for an agreed-upon interest rate. While they don’t typically have the growth potential of other investments (including stocks), there is generally a lower risk of losing principal and a more predictable return stream for the investor.

• Real estate: Real estate investment may include buying properties to renovate and sell at a profit, purchasing and renting out properties for ongoing income, and participating in real estate investment trusts (REITs). There is the potential for high payoff, but no investment offers guaranteed success. Financial risks to real estate include vacancies, non-paying renters, property damage, and loss of value.

• Commodities: Commodities include physical commodities (like gold) or commodities-based mutual funds, ETFs, and derivatives. Commodities may include precious and industrial metals, oil, and agricultural products like wheat or cattle. They’re often considered an alternative investment strategy, and may offer protection against inflation.

• Cash and cash equivalents: Cash investments may include money market funds, certificates of deposit (CDs), cash sweeps, and more. In many cases, these products allow you to keep your cash relatively accessible but may offer higher yield returns than keeping the money in a standard savings account.

• Alternative asset classes: This asset class may involve other investments, including private credit, private equity, real estate, hedge funds, and more. They typically aren't as regulated as traditional asset classes, and while they offer growth potential, in many cases, the underlying assets may have less liquidity, and thus challenging to convert to cash when needed.

Why does asset diversification matter? Here’s a simple scenario to help explain. Many people have portfolios that are heavily concentrated in stocks, because they are looking for high overall returns to grow their wealth quickly. But if, for example, the stock market suffers a downturn around the time you stop working, you could face significant losses that will be difficult – if not impossible – to recoup as you start depleting your nest egg with retirement withdrawals. An ongoing and dynamic diversification strategy that considers the age and risk tolerance of an individual can be effective at maximizing gains early in life and then mitigating the risk of loss as retirement approaches.

2. Diversification within asset classes

Even sophisticated investors don't always spread their money evenly across all asset classes. Many tend to focus most of their investments on the one (or two) specific asset classes that they know best.

Examples of diversification strategies within the same asset class may include:

• Investment Styles: Investment styles are different ways to pick investments based on factors like company growth, stock price trends, dividend payout rates, or valuation. Some styles do well in certain market conditions but struggle in others. Using a mix of styles helps balance risk and improve returns over time.

• Business Sectors & Industries: Diversifying investments across different business sectors can help protect against market volatility. During the COVID-19 pandemic, for example, the hospitality industry stocks were hit particularly hard while many pharmaceutical companies increased in value. And in real estate, commercial properties saw broad declines, but residential real estate flourished.

• Market Capitalization: Market capitalization sorts companies by size — large, mid, or small — each with different risk and growth potential. Large companies can be more stable, while smaller ones can grow faster but can be more volatile. Investing across all sizes can help to create a balanced portfolio.

• Geography: Diversifying your portfolio to include both domestic and foreign investments can help you potentially protect against factors like inflation or harsh economic conditions in one region impacting your total portfolio’s value.

• Maturity (fixed income): Some investments have “maturity periods” that dictate when the investment period has ended. This is most commonly found in bonds but may also characterize alternative investments like private equity funds.

• Bond Sectors: Bonds come in different types, like government, corporate, and municipal, each with its own risks and benefits. They react differently to changes in the economy and interest rates. Owning a mix of bond types can help manage risk and steady returns.

• Tangibility: Tangible assets — including “alternative” investments like gold bullion, collectible cars, or fine art — can help diversify a portfolio because they don’t typically correlate with stock and bond market performance. Tangible assets that increase in value over time may also offer protection against inflation.

3. Diversification by platform

Some financial planning strategies include diversifying investments across multiple financial institutions and investment platforms. There can be several reasons for this:

• Protection against bank failure: While unlikely, bank failures occasionally happen. The FDIC insures up to $250,000 per depositor per FDIC-insured bank. If you have more than $250,000 on deposit, creating accounts at different banks may make sense.

• Minimize the risk of service disruption: If you’re concerned about potential service disruptions from one bank, brokerage, or institution you can have accounts with different banks to increase the likelihood of access to funds at all times. Service disruptions can be especially concerning for people with assets in smaller banks and boutique investment firms.

• Taking advantage of relevant offers: If you're holding significant cash reserves, it can pay to look around for banks and institutions that offer incentives and/or high interest rates for new accounts or qualifying deposit levels. Many people continually look for the best deals on cash deposits and rotate their funds in and out of banks as needed to take advantage of the best offers.

Example: A simple diversification strategy

Your needs are unique, and that should be reflected in your investment portfolio. Generally speaking, the shorter your investment timeframe, the less risk you want in your portfolio. But with those caveats, here is one example of how a simple portfolio diversification strategy might look:

• Invest 50% in stocks: Within this asset class, you could further diversify your investments with a combination of broad index funds that track the stock market as a whole, plus a few higher-risk stocks with up-and-coming companies or sectors you believe to be particularly promising.

• Invest 20% in real estate: For example, purchasing a rental property generates rental income in excess of holding costs (i.e., mortgage, maintenance and taxes) while also serving as an appreciating asset.

• Invest 20% in bonds: This would serve as a more conservative, low-risk part of your investment portfolio, providing slow, stable growth.

• Invest 10% in liquid funds: It’s a good idea have access to liquid cash-equivalent funds, such as money market funds, short-term treasury bills in case of an emergency or unexpected expense.

The importance of diversification in trusts

Trusts are legal entities that can hold assets on behalf of another person (or group of people). They are commonly used in estate planning to distribute assets to a person's heirs. In a trust, those heirs are called “beneficiaries” — those who receive the assets. There is also the grantor, who provides the assets, and the trustee, who guards and controls the assets with a fiduciary responsibility toward the beneficiaries.

There are many different types of trusts with varying tax treatment benefits or features. Some are irrevocable, meaning the grantor relinquishes all ownership and control of assets in the trust and cannot change it; others are revocable and may be changed or even dissolved after the fact. Trusts used for estate planning purposes include:

• Irrevocable Life Insurance Trust: An irrevocable life insurance trust (ILIT) holds and controls a life insurance policy, including any cash value while the grantor is still alive. It can be used to shield the policy’s death benefit from estate taxes.¹

• Grantor retained annuity trust: A grantor retained annuity trust (GRAT) is an irrevocable trust that can significantly reduce gift taxes owed. As the grantor, you can transfer assets into the trust and receive annuity-like payments for a specified term. The amount remaining when the payments end goes to your beneficiary. GRATs are useful for shielding appreciation, as the grantor is responsible for paying income tax on trust income.²

• Intentionally defective grantor trust: This is an irrevocable trust that can help shield assets from estate tax. The “defective” component refers to how assets are owned and taxed: even though the grantor relinquishes ownership of assets in the trust to remove these assets from the estate, the grantor still pays income taxes on any income earned from the assets in the trust.³

• Spousal lifetime access trust: This irrevocable trust type allows one spouse to gift assets to the other spouse, who is the beneficiary. The assets in the trust, which the beneficiary may access, are excluded from their taxable estate.⁴

• Generation transfer trust: Also called a generation-skipping trust (GST), this is an irrevocable trust created to provide a vehicle for grantors to skip their children and gift assets to their grandchildren. Generation transfer trusts aim to avoid estate taxes; they are still subject to generation-skipping transfer tax (GSTT) on assets beyond the exclusion amount of $13.99 million for individuals and $27.98 million for couples.⁵

Wealthy individuals with very large, complex estates may choose to set up a diverse array of trusts to serve the needs of different beneficiaries or interests. A simple example would entail putting some assets in a revocable trust in order to retain control over them, and putting other assets in one or more irrevocable trusts to remove them from the taxable estate.

However, trust diversification doesn’t typically refer to using multiple trusts in estate planning - More commonly, it’s about investment diversification in the traditional sense. Investment diversification is an important issue for grantors setting up a trust – and a critical issue for the trustee who administers it:

• Trustees are fiduciaries who must abide by the Uniform Trust Code, which requires them to act "prudently" when administering a trust, and the Uniform Prudent Investor Act, which states that absent special circumstances, a trustee "shall diversify the investments of the trust".⁶
  The trustee will also have to consider how assets are distributed from the trust, especially if the intent is to create steady, ongoing income for beneficiaries. A well-diversified portfolio can facilitate this by including income-generating assets like dividend-paying stocks and bonds, and allow for more flexible distribution by providing a mix of assets with varying risk profiles and liquidity levels.

Note that trusts are not suitable for everyone and every estate: they are complex legal documents that can be difficult to understand and can require a significant investment of time and money to set up. Ongoing administration fees can also eat into your assets, and the terms of an irrevocable trust typically restrict your decision-making. If you’re thinking of using trusts for your estate, your tax, financial, and estate planning advisors can help you decide whether a trust is right for you and which type or types could be most suitable. But you should also ensure that your trustee understands their obligations concerning investment diversification — particularly if that person is a family member (such as an adult child) instead of a professional trust administrator.

The pros and cons of diversification

As with any investment concept, there can be advantages and disadvantages to the concept as a whole, as well as a given diversification strategy. Potential advantages generally include:

• Limiting idiosyncratic risk: Idiosyncratic or concentration risk is unique to a specific company or industry and can be reduced through diversification, which spreads out investments across diverse asset types or classes.

• Balancing risk: If you intentionally invest in a combination of high-risk and low-risk options, you can protect your overall investment while still managing with an objective for long-term growth.

• Reducing dependence on a single source of income: If your estate starts to distribute assets when the stock market is at a ten-year low, it will likely make more sense to source withdrawals from other asset classes first, such as real estate, commodities, or cash equivalents.

There are also potential disadvantages to diversification, especially for smaller and less sophisticated investors:

• Complication: Some people struggle to determine how to invest their money. Creating and implementing a diversification strategy undeniably requires more effort than putting money in a CD account or investing into a single index fund.

• Investment selection: Selecting the most appropriate investment from a variety of seemingly similar options can be difficult, and requires considerable expertise.

Guardian can help

Investment diversification can be a challenge. Don't know where to begin? A Guardian financial professional can help you create and implement a personal finance diversification strategy based on your goals, risk tolerance, investment timeframe and other factors. And all it takes to start is a simple conversation.