Why is Diversifying Your Wealth so Important?

 Diversification

When I was single and dating, I had several wise friends and family members tell me not to “put all your eggs in one basket.” Anyone that has much experience in dating knows the value of the phrase, cliche as it may sound. Opportunities tend to come and go in the dating world. Getting your heart set on one person (especially early on) and having it not work out can lead to unnecessary heartache. A better approach is often to go on dates with a variety of people.

In the financial world, we tend to use a comparable but more nerdy term for “not putting all your eggs in one basket.” It’s called diversification.

WHAT IS DIVERSIFICATION?

Diversification is spreading your wealth across a wide variety of investments instead of concentrating all of your money in one or two. The goal is to decrease risk while potentially improving returns over the long-run as well.

WHY DIVERSIFICATION MATTERS

Diversification across a variety of assets implies that not all investments behave the same, and this is often the case.

For example, during the financial crisis in 2008-2009, the stock market dropped around 30-40% in 2008 alone. From January to March 2009, it lost another 20% or so. That’s roughly 50-60% of its value! However, the bond market actually gained a few percentage points over this same period.

On the other hand, the last 8 years since the financial crisis have been a “bull market” (a market of continually increasing asset values) for stocks. Bonds have also done well, but not as well as stocks.

Stocks and bonds don’t have a perfectly negative correlation--stocks aren’t the “yin” to bonds’ “yang”--but they don’t move perfectly in step with each other either. Bonds are relatively safer than stocks so investors tend to flee to bonds for safety in hard times, but stocks contain greater potential for long-term growth. This example of assets behaving differently is one of the characteristics we look for with diversification.

HOW DIVERSIFICATION WORKS - A PERSONAL EXAMPLE

As an early investor and newly minted finance graduate, stock picking fascinated me. On a “hot tip” from a co-worker I invested in a company that was doing well and appeared to have a solid future. In late 2006 I invested what felt to me like a pretty big chunk of money. That’s when disaster hit.

This company suffered two pitfalls within a few years of my purchase (just my luck). The financial crisis in 2008-2009, and shortly thereafter a major equipment accident in 2010 that brought on significant company liability. Several years later this “ship” (and my investment) was sunk.

 ...or stranded. You get the point.

...or stranded. You get the point.

Financial markets are unpredictable, but we invest with a certain degree of confidence that businesses--ashore and abroad--have strong incentives to innovate and grow. Unfortunately, there are still winners and losers and it’s nearly impossible for investors (amateurs and professionals alike) to understand how one company is going to perform over a long period of time. I thought I knew...and I got taken to the cleaners.

DIVERSIFICATION IS EASIER THAN YOU THINK

Diversification means we don’t have to be professional stock pickers. In fact, we don’t even need to play the game. Spreading your dollars across a wide range of investments eliminates the risk of losing all your money in one failed venture.

Fortunately most investors have access to a variety of well-diversified investments. They’re called mutual funds and are available in your 401(k), IRA, or taxable investment account.

Instead of buying stock in one or two companies, mutual funds are made up of the stocks and/or bonds of hundreds and thousands of companies. They may also contain assets like real estate and commodities as well. The point to understand is this: The impact of one company going bankrupt within a mutual fund would be far less severe because your money is spread across many other companies as well. This is where diversification can prove so valuable.

This same principle applies to any other type of “basket” (or asset classes) you may use for wealth building purposes--stocks, real estate, precious metals or even your own small business. The potential for one single investment to lose it’s value and take your entire investment with it can be tempered by spreading your capital across a variety of other asset classes.

HOW A LACK OF DIVERSIFICATION CAN GET YOU IN TROUBLE

Let’s look at a couple sample scenarios where a lack of diversification could potentially get a family into financial trouble.

Example 1: The Rental Property Family

The Smith family has always enjoyed owning real estate, so over a period of years they identify a single family rental, a duplex, and a small 4-plex in a growing community within their hometown.

Because of the required capital for purchasing investment properties and their desire to live nearby to better manage their rentals, they put off participating in their company 401(k) plans and pass up job promotions which would take them outside the state.

Initially it may seem that this family has a fair amount of diversification in that their investment is spread across a variety of different homes which likely appeal to different types of renters, based on income level for instance. Also, perhaps these rentals are in a thriving community with strong rental rates!

But what if these rentals were in a coal mining community? Mining jobs were abundant through the 1990’s and 2000’s, but then multiple coal plants to shut down resulting in significant population decreases in these communities. (In case you haven’t seen in the news, this is exactly what’s happening in coal mining towns across Wyoming.)

The Smith’s rental properties may be subjected to significant long-term vacancies and loss of value, seeing as they’re in a town where future growth prospects have been dashed within a relatively short period of time. Having other assets in their wealth-building arsenal could have lessened the blow.

Example 2: The Businessman With Company Stock in His 401(k)

Jeff has worked at a successful bank for his entire 15-year career, taking multiple promotion opportunities along the way. The company has great benefits, with a generous 401(k) company match. The match goes toward purchasing shares of company stock.

As Jeff has moved up the ranks, his salary has increased and as a result his company match has gone up as well. After 15 years, Jeff has $300,000 in his 401(k). Nearly 40% of its value is in company stock, while the other 60% is spread across several different mutual funds. Besides the $60,000 in equity Jeff has in his home, he has no other financial assets.

Do you notice any problems in Jeff’s case? He’s certainly doing well at his job. From the human capital standpoint Jeff is truly finding awesome opportunities to use his greatest asset.

But a substantial amount of Jeff’s total wealth is tied up in the potential success or failure of his employer. Not only is Jeff’s wage income completely reliant on the business, but a growing percentage of his 401(k) (and his future retirement benefit) is as well.

Times may be good for Jeff’s employer, but having such a large amount of Jeff’s wealth tied to the performance of one company presents a significantly higher degree of risk and a lack of diversification, compared to spreading the risk across other investments.

I hope this article has been helpful. Wise investors acknowledge that no one knows which asset classes will do the best over time. Instead of looking into a magic 8-ball for answers, they spread their wealth across a variety of asset classes. Diversification isn’t a guarantee against loss, but can help investors better weather the ups and downs that will inevitably come.