From the Bible to Aesop's Fables to modern portfolio theory (MPT), the concept of diversification—not putting all your eggs in one basket—as a means of reducing risk has been around for more than 3,000 years. But investors and the financial advice industry often focus solely on diversification across asset classes within a portfolio. They should broaden their perspective to include wealth management strategies—specifically, to reduce their exposure to the uncertainty of future taxes and planning horizons.

Diversification reduces risk and regret

Diversification is nothing new. The Talmud, for example, advised people to evenly divide assets between business, cash, and land. Harry Markowitz, the Nobel laureate and father of MPT, took the concept to another level, showing that diversification can potentially generate higher returns with lower risk. Perhaps that's why diversification is often said to be the only free lunch in investing.

Diversification is an acknowledgment that we can't predict the future. It's also a means of hedging that uncertainty. This is why we buy a basket of securities rather than concentrate in a single one, hold both domestic and foreign assets, and allocate to stocks and bonds in proportion to one's risk tolerance. This diversification story has become a key tenet of building prudent investment portfolios and is a crucial element of Vanguard's Principles for Investing SuccessOpens in a new tab.

Still, let's acknowledge that hindsight is 20/20. An investor can always look back to see where they could have made more money. But diversification helps minimize that regret.

Diversification goes beyond portfolio construction

The benefits of diversification extend beyond one's investment portfolio. Two critical elements of wealth management stand out to me: tax risk and longevity risk. In an industry that manages clients' wealth, we tend to acknowledge these risks but don't necessarily apply the powerful concept of diversification to mitigate them.

But, by diversifying the way we think about diversification, we can help reduce risks in ways that investors may not even realize.

What tax diversification looks like

What will a client's tax rate look like in the future? It's hard to know, when changes like marital status, income level, and required retirement withdrawals can easily push an investor into unexpected tax territory—and that's assuming no changes to current tax law. That's why we have an obligation to prepare client portfolios for the possibility of higher or lower future taxes. We just can't know how tax costs will change over an investor's horizon.

A diversified approach that spreads assets across accounts with different tax structures can help reduce some of that risk. Further, a tax-efficient approach when contributing to and withdrawing from investment portfolios can lower the overall costs of investing.

A strategy I like includes using a mix of traditional (tax-deferred), Roth (tax-free), and after-tax (for those who have reached retirement contribution limits) accounts to manage tax exposure before and during retirement.Such a mix can spread risk across accounts that offer tax-deferred and tax-free treatment for earnings, as long as certain conditions are met.* Diversification across tax treatments can be achieved by splitting contributions among accounts or by converting current traditional assets to Roth. Through either method, holding both traditional and Roth accounts can help reduce a client's tax uncertainty.

Of course, there's no one-size-fits-all approach when it comes to tax diversification. The ideal mix of assets depends on an investor's goals, timeline, and expectations for future tax concerns. Costs matter, as I've written beforeOpens in a new tab, and diversifying across account types can help lessen what's arguably one of the largest expenses associated with investing: the impact of taxes.

Income diversification reduces longevity risk

Living beyond one's life expectancy is a wonderful problem to have but a potential nightmare from a wealth management standpoint. Retirees and pre-retirees want to know how much they can spend today while making sure they're saving enough for the future. A diversified approach to retirement income, supported by savvy portfolio allocations and spending strategies, can help investors offset longevity risk while still fully enjoying life.

A discussion of all the potential considerations could fill a book, but the most obvious is when to claim Social Security. Benefits can start as early as age 62 or as late as age 70. The longer an investor waits to claim their benefits, the higher their payout will be. Early claiming can reduce one's annual Social Security benefits by as much as 25%, while delayed claiming can increase it by as much as 32%. Claiming strategy also impacts spousal and survivor benefits.

In many ways, Social Security benefits are essentially an annuity paid by the government, so many of the same considerations apply to Social Security claiming as to annuities, including an investor's health status, available assets, and desired and required spending. For those in good health who can afford to do it, delaying Social Security can be a powerful income diversifier.

To reiterate, the benefits of diversification apply to more than just portfolio construction. Diversifying is a risk management technique that can help temper future uncertainties. A well-diversified approach to both investments and wealth management can help safeguard an investor's financial future.

*When taking withdrawals from an IRA or tax-deferred plan before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax. Withdrawals from a Roth IRA or 401(k) are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made.)

Note:

• All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. We recommend that you consult a tax or financial advisor about your individual situation.

Vanguard funds not held in a brokerage account are held by The Vanguard Group, Inc., and are not protected by SIPC. Brokerage assets are held by Vanguard Brokerage Services, a division of Vanguard Marketing Corporation, member FINRA and SIPC.