Diversification is one of the most well-known words in the investment lexicon. However, even today, there are still misunderstandings and misapplications of diversification. In the text above, we can see that this concept goes back to ancient times. But, what does it mean?
If diversification is such a well-known idea, why do some investors still get this wrong? Or, why do some investors not understand the many different types of diversification? Let’s explore some ideas together.
Being Diversified
What does “being diversified” actually mean? A typical response is, “You own many different investments or asset classes inside of your investment portfolio.” This isn’t wrong, but I think it may be incomplete.
Let’s start with a basic framework. In my view, we should include everything you earn and everything you own that is considered part of your wealth equation. For many people, this may include their primary residence and home equity. For others, it may include ownership in a small business. The point is to look at the entire picture.
Here are a couple of quick examples:
Think of a small business owner who owns a company that could be valued at 3 million. This same business owner has a small 401(k) balance of $150,000 invested in equities and $300,000 in cash at the bank. It’s not uncommon for people to only look at the 401(k) balance when considering diversification. However, the 3 million-dollar company is also equity ownership, and you cannot ignore the cash either.
Imagine an employee who works at a technology company. This person makes a phenomenal salary, has stock options, receives stock grants, and has a small company 401(k). This employee loves their job and the company's vision, so they are loaded on company stock. This is a classic mistake of having your job and personal financial assets tied to 1 business. What could go wrong? (Think Enron)
Here’s a breakdown of how I might view the diversification of the business owner in the first example:
Human Capital
Highly specialized
High earning potential
Income variability is low to medium, with big upside potential
Income risk w/ recession is medium
Financial Capital
3mm present value of small business equity; high upside, low liquidity (Taxable)
$300k cash; low upside, high liquidity; inflation risk (Taxable)
$150k 401(k) balance; high upside, medium liquidity (Tax Deferred)
$400k in home equity; low to medium upside; low to medium liquidity
Social Capital
Salary maximized FICA taxes for Social Security / Medicare
Eligible for SS benefits at 62yrs
Medium Risk of reduction of benefits in future
When you look at this breakdown, what do you see?
Do you see any areas of concern? Any gaps?
Most people will consider diversification only by looking at the 401(k). But what about everything else? When viewed in context, the 401(k) appears to be the smallest financial asset. Do we just ignore the other assets and the role they play?
I don’t think you can. A comprehensive wealth planning strategy must consider the total picture. Failing to do this may result in serious gaps in the overall financial plan.
Diversification in Investment Strategies
How do you diversify a portfolio? Don’t worry; we won’t dive deep into mean-variance optimization, modern portfolio theory, or lifecycle investing. I believe the more jargon financial planners use, the more the message gets lost.
Let’s simplify things.
The main ideas behind portfolio diversification are:
Use various types of investments and assets
Seek to minimize the possibility of a catastrophic loss from any one endeavor
Maximize the potential return on investments for the level of risk (volatility) you are willing to take
If you look back at the Bible verse above, this is what it means. We don’t know what may happen or what disaster may strike, so we should invest in multiple ventures.
What does this mean in practice?
The truth about being in a diversified portfolio is that you will likely always own something that isn’t doing so well. This is normal, as different assets often have different economic cycles. The key is not to get discouraged or to make emotional adjustments when one piece of the pie isn't working at the moment.
The goal is to avoid catastrophe (first) and build wealth (second). In ancient times, people knew this because it could mean the difference between life and death. Hopefully, the stakes for us today are not that high. However, we would be wise to apply this principle to our investments today.
*Thanks for reading. Diversification is a deep subject, and I will likely touch on it again. We didn't event talk about tax diversification in this post. We'll save that for another day. In the meantime, here's a Youtube video of mine on this topic. Enjoy.