Dear Dr. Don,
I am just getting into the investment world. Everywhere I look, it is suggested to diversify. With many of the recent economic troubles in the financial sector, I am wondering if "diversify" should extend beyond the portfolio to include financial service companies.
For example, my employer-sponsored retirement plan is through TIAA-CREF and I match their contribution, but I would like to open a Roth IRA. Should I go with another company, like Fidelity, or just stick with TIAA-CREF? Is this level of diversification leaning on paranoia or somewhat sensible?
-- Concerned Casey
This is a great question. You're talking about two different types of diversification, and alluding to a third -- tax diversification with a Roth IRA.
Contributions to an employer's 401(k) or 403(b) matching program are tax-deferred unless you're contributing to a Roth 401(k) or Roth 403(b) plan. I'm going to assume that you're making tax-deferred contributions to your employer's plan.
Additional contributions to a Roth IRA, assuming you're eligible to make those contributions, would be made with after-tax dollars. Investing in a Roth IRA will give you a measure of tax diversification, as qualified distributions from a Roth IRA are free of federal income taxes.
You are considering diversifying across firms. However, investment firms encourage individuals to consolidate their retirement accounts under one roof and often entice investors to do so by offering advantages, including potentially lower fees and access to additional services at reduced or lower cost.
The typical risk of investing in mutual funds comes from the riskiness of the investments held by the fund, not the risk of mismanagement or fraud by the investment company offering the mutual fund.
Research done on the topic shows that there may be a benefit from investing across mutual fund families. However, the Vanguard investment management company publication, "Diversification: Myths and misconceptions," does a nice job in reassuring investors that "group think" isn't an overarching problem in building a diversified portfolio within one family of funds.
Assuming investors are working with an investment company with a long and stable history -- like Vanguard or Fidelity -- my rule of thumb is they don't need to diversify by investment company until their retirement accounts are over $100,000. (Once you get to six figures, you should start to realize some additional perks from your existing relationship and you've reached critical mass in the selection of investments with that family of funds. So, it may be a good time to look around and see what else is available as a home for your retirement investments.)
If you're just starting out, the SEC publication, "Invest Wisely: An Introduction to Mutual Funds," provides a nice primer on mutual fund investing. Simply distinguishing among stock, bond and cash (money market) investments is painting with too broad a brush. Instead, investors building a retirement portfolio should diversify across asset classes.
Defining appropriate asset classes is a great start. For example, you'll want to consider how you invest your stock allocation by industry, market capitalization and country. Alternate investment classes such as real estate, commodities and precious metals also should be considered when building and appropriate asset allocation.
When starting out, it generally makes sense to buy a few broadly diversified mutual funds instead of investing in a large number of mutual funds with concentrated holdings. I'm not a big fan of target-dated retirement funds, but these funds can be a good place to start investing if you just can't decide on your own where to invest. You can change funds later, as appropriate.
Finally, in the interest of full disclosure, it should be noted that I have retirement accounts with Vanguard, Fidelity and TIAA-CREF. The fact that I mention these firms in my answer should not be construed as investment advice or recommendation of these specific firms or the funds they offer.
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