If there’s one timeless investing principal that trumps all others, diversification certainly ranks up there right at the top.
Ask 100 people on the street to describe what diversification means to them and you’ll probably get 100 different answers. We all interpret things slightly differently, which is why it’s important to lay down some clear definitions up front so we’re all on the same page.
I’ll start with the common misconception that diversification is about getting “better returns” – this isn’t true.
Diversification is first and foremost about mitigating risk, not about producing better returns. The two aren’t mutually exclusive, but it stands to reason that you have a better chance of getting a higher return on investment when you’re willing to take on more risk.
And although it doesn’t provide a guarantee against loss – as losses can and will occur – diversification is a key fundamental money management strategy that must be implemented in order to reach your long-range financial goals while minimizing risk.
If you study the investment patterns of families and their wealth that’s survived over a period of many generations, you come to understand that diversification has a much deeper meaning for those who want to thrive in every possible economic and political situation that can arise.
The purpose of this article is to cover the most important aspects of accomplishing true diversification in your portfolio.
The term “portfolio” usually refers to a collection of investments that an individual owns. Your portfolio spans across your whole life, and we sometimes tend to forget that it goes beyond just being a reflection of what we put directly into our investments specifically for retirement.
To get a more complete picture of what your portfolio is, it may be easier to think of it as a representation of your net worth. Looking at your portfolio from that perspective allows you to zero in on which assets may be under or over allocated so you can plan accordingly.
Knowledge and experience are the most valuable assets you can own, and one thing I’ve noticed over the years is that too many people buy into the dream of passive income, but not the process.
What I mean by that is, developing multiple streams of passive income isn’t something that happens overnight, and even though we may be focused on growing our money in a very hands-free passive way, it still requires a proactive approach and a sound money management strategy.
“Never put all your eggs in one basket” – You’ve probably heard this wise adage over and over again throughout your life, however this golden rule of investing is often misused and misunderstood.
Even though the concept of holding a well-diversified ‘basket’ of investments in different financial asset classes and industries to reduce risk exposure sounds like common sense, it’s not correctly being followed by many investors.
Some investors simply don’t understand what having a diversified portfolio truly means, and yet others choose to ignore it altogether.
But as you’re about to find out, there’s more to diversification than just picking a few ’set and forget’ IV’s (investment vehicles), plunking down your money, and turning things over to someone else.
The cornerstone of all successful long-term investing revolves around three things: market diversification, asset allocation, and risk management.
And as any financial advisor and in fact, anyone with a little common sense will tell you, the best way to protect your portfolio is by diversifying your risk capital into different types of investments and asset classes.
That way, you’re able to minimize the possibility of a single investment or asset class totally devastating your overall portfolio performance.
These asset classes have traditionally been a blend of stocks, bonds, CD’s, and mutual funds of one form or another.
Frankly, I cringe whenever I hear well-meaning investors – the ones who’ve only played it safe their whole life – suggest that everyone should load up their retirement portfolios with low-yielding bank CD’s or Treasury notes that lock up their money for 5 – 10 years as a “hedge” against a stock market crash, terrorist attack, or natural disaster.
Not only will these types of investments have you barely treading water to keep up with inflation (the invisible tax), but your overall risk can significantly increase when the majority of your investment portfolio includes asset classes which are closely correlated.
Investment Strategy
Lots of people have goals… they just don’t have a strategy to achieve them. There’s an old expression, “If you fail to plan, you plan to fail.”
While most rational people wouldn’t take a trip to a place they’d never been before without some sort of road map or directions, way too many investors try to navigate the financial world without an investment road map.
So before you invest a single dime, you not only need to have clear goals, you also need a strategy for reaching those goals. This is where your risk tolerance combined with your investment style all come into play.
But there’s a caveat: With so many different types of individual investments to choose from, things can quickly become very confusing, especially if you haven’t done your research or don’t know where to start.
Like wolves in a hen house, traditional investment firms use “convenience” as their main selling point to convince you to invest your hard-earned money with them, and then leave it in their hands until your financial goals are met or until you retire (if that happens to be your goal).
But this approach to growing your nest egg is way too risky in my opinion. To me, it makes more sense to adopt an investment strategy that starts to improve your current income and allows you to recover your principal much sooner rather than later when you may be too old to enjoy it (or never get to enjoy it at all).
A licensed advisor can make sure that you’re not investing more than you should (or less than you should), and help you with calculating and determining what needs to happen for you to reach your financial goals.
Whether you decide to enlist the assistance of a licensed professional or not is secondary to your ability to be able to honestly answer important questions related to the financial security for you and your family…
Questions like: what do you hope to achieve with your investments?
Will you be funding a college education? Buying a home? Retiring soon?
Do you have the intestinal fortitude (guts) to tolerate the roller-coaster ride and potential losses that are associated with high-risk investments?
Do you have enough years on the horizon prior to retirement and enough savings already stashed away to be able to rely on more conservative passive investment returns, or do you require higher returns to meet your retirement goals?
These are just a few brief examples of the types of questions you need to know the answers to in order to get the maximum benefit from diversification.
Investing is much like a game where you don’t know the outcome until the game has been played and a winner’s been declared. Anytime you play a game, there’s usually a strategy that can be used to increase your chances of winning – investing isn’t any different.
Investing works best when you keep it simple. People like to complicate everything related to investing, and in turn, make it harder than it really is.
Successful investing is like gardening, not winning the lottery. You’ve got to plant lots of seeds ’cause the birds are going to get some of them.
Some will grow and others will wither away, and there will always be some routine weeding to do (and the occasional pests to deal with).
But as long as you manage things properly (and keep your “greed monster” in check), your investments will have the best chance of continuing to grow.
Water them and tend to them. You can nudge them a little, but rapid growth is usually shaky and weak, and can collapse on you. After a while, you’ll have several growing “money trees” that will eventually reach a level where they take off and are generating a healthy passive income for you.
Wealth is achieved through a combination of how hard you work, how much you earn, and how much your money earns, including how long it compounds.
Regardless of your long term goals, creating a consistent passive income isn’t always easy, but as long as you know what you want, have a plan and stick to it, there’s nothing that can stop you from achieving your financial goals.
If you’re already enjoying life at the higher stages, congratulations! I’ve found that the fun is in the journey, not the end result.
So hang onto the fundamental money management principles I’ve shared with you in this article and make small incremental adjustments from time to time.
Brad Wajnman is Managing Editor of The Wealth Vault, an alternative investments membership club that lists unique, under the radar higher-yielding investment opportunities and passive income systems, resources and contacts that allow members to generate automated “hands-free” income. For more information visit http://www.WealthVault.net