This weekend we will be celebrating Easter, the resurrection of Christ. We often celebrate this monumental event with an Easter egg hunt. Those Easter eggs got me thinking about the old saying; don’t put all your eggs in one basket.
Diversification is one of the key elements to successful investing. I looked to Wikipedia for a definition and found diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A diversified portfolio will have less variance than the weighted average variance of its constituent assets.
King Solomon had this to say about diversification in Ecclesiastes 11:2, “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” Even after 3,000 years, diversification is still important. So how does one diversify? (Hint – It’s not just buying mutual funds. I’ll show you exactly how I’m diversified as an example.)
Diversifying your investments is not just owning an assortment of investments, as there are multiple forms of diversification. If you own several different tech stocks, that wouldn’t be very diverse. You can diversify your investments by owning different industries, risks levels, or geographic locations.
Owning individual stocks can be risky. You minimize that risk by spreading out those stocks into different industries. You might own agriculture, technology, utilities, transportation, banking, communications, retail, healthcare, industrial, mining, and many more.
If you own stock in only one of these areas, that area could have a new governmental regulation that cause all the stock values to plummet, and your portfolio could disappear. But if that sector only accounted for 1/7 of your portfolio, its fall would not cause too much damage.
Different investments have different risk stratification. Drilling oil wells and buying bitcoin are very risky investments. Buying bank certificates of deposit are very safe investments. It’s important that you spread out the risk. Very little of your portfolio should be invested in high risk endeavors. But if you only invest in the very low risk investments, your return will be very small.
The reason people choose the higher risk investments is because they have the potential for a very high return on their money. It is exciting to invest with a possible 400% return compared to a guaranteed 3% return.
Making the right comparison is important when making your decisions. That 400% possible return might have a 5% chance of success, and a 95% chance of getting a return of zero and losing all the principal. Whereas the 3% return has nearly a 100% chance of success of both receiving the agreed upon interest and getting the principal back. When investing, the idea is to increase your wealth. The risk of losing all the money needs to be minimized.
To maximize your return, you need to find a good balance of the two, risk vs return. If you are diversified, there is little risk involved in increasing your return to the 8% – 10% range. There would be a lot of risk involved with trying to increase your return to 40%.
Diversifying by location is a great way to lessen your risk. For example, the Chinese stock market will not follow the US stock market exactly. Buying all your rental real estate in one town that is supported by only one factory leaves your investment at the mercy of that factory. Agricultural investments that are solely based in Florida could be wiped out with a hurricane.
Spreading your investments over different geographic locations takes another volatility factor off the table. If a natural disaster hits one location, and everything you own is there, you could be wiped out. I recently visited the town of Paradise, CA. Last fall a forest fire went through the town and burned up many of the homes and businesses. Some entire neighborhoods were destroyed. Everyone who lived in that town has been affected by the fire.
Although many lost everything, some people had a big increase in income, the construction and demolition industries come to mind. Since we were traveling in our motorhome we wanted to spend the night near Paradise. We could not find a single spot in any of the nearby RV parks. They were full of displaced people. If you own one of those parks, you are now experiencing great prosperity, since you have been and will continue to be full to 100% capacity for the next few years.
Contrary to popular belief, investing in the stock market is only one type of investment. You might think if you buy eight different stocks, spread out in the manner listed above, that you would be diversified. You would not be. That would make your stocks diversified, and less volatile, but I would only count that as one type of investment, and you are shooting to have several types. If all you have is the stock market, and it tanks, then your entire portfolio tanks with it.
The best way to invest in the stock market is with mutual funds. One single mutual fund purchase that includes 1,000 different businesses is a great and easy way to diversify. I would recommend you invest only in index mutual funds. These tend to have low expense ratios, (the expense is what the fund charges to manage the fund for your benefit). Two examples are: a total stock market index fund, or an S&P 500 index fund.
So you might pick a few, 3 – 5, funds that would make you even more diversified. Such as putting one third in an S&P 500 index fund, one third in a European total stock market fund, and one third in a utility index fund. There are many ways to pick a few different sectors to invest in and an almost unlimited combination of ways to diversify using mutual funds.
Real estate is another great place to put your money that creates diversification. I’m not talking about owning a real estate investment trust (REIT) which is a stock market sector. I’m talking about actually owning real estate that you bought for the purpose of making money.
There are ways to diversify real estate. You can own multiple units, in multiple locations. You can own different types of real estate like farm land, single family homes, apartments, storage units, condominiums, vacation homes, and commercial buildings.
You can also own real estate in different geographical locations. Rural and urban, ski areas and beaches, northern and southern.
No matter how much you might like this sector, and I like it a lot, it can’t be the only sector you invest in, even if you diversify within it. This is for the same reason you should not invest only in the stock market.
Owning individual businesses is another way to branch out and become diversified. There are so many different types of businesses to own that it is easy to diversify within this sector. Businesses have a high overall failure rate so you must consider this on the more risky end of the spectrum.
You could be the co-owner of a surgery center, an MRI machine, an equipment rental company, a candy factory, a restaurant, a bike shop, a website, a flower shop, a construction company, a specialty store, a book store, a drilling company, a new product, a durable medical equipment supply store, multi-level marketing, a publishing company, a manufacturing company, a farm, and any other business that needs a partner.
These are investments, not the place you work. As a physician, I have been approached by lots of businesses on this list. Physicians are often thought of as people who have lots of money to invest, so businesses come to us when they are looking for a partner. The investor is often required to be “qualified” and must meet certain criteria that include income and net worth thresholds. Then the investor is deemed to be experienced enough to know what they are getting into. That is not always the case.
Be careful with businesses, they are very risky. The single biggest loss I ever had was a business I invested in. Several businesses I’ve been involved in do not exist today. Many made good money for a while and then folded. Others never got off the ground. Some have done very well. Be sure you are investing in businesses that you are familiar with. The more you already know about that industry, the better your chances of making a good investment.
These are places you invest where your principle is used to help someone who needs cash to purchase an asset, such as a house, or a business. You will get paid interest for the use of your money. Savings accounts, certificates of deposit, money market accounts, private loans on real estate, and bonds come to mind. These tend to be very safe but produce a smaller return. Less risk means less reward.
Your Own Labor
Don’t forget to invest in yourself. The work you do is often your biggest money producer. As a physician, my job was a great money maker and investing in myself had a good return. The investment I made was medical school, residency and continuing education. That may have been my best investment of all.
So what might a well-diversified investor’s portfolio look like? I’ll give you an example of what I have included in my portfolio during my lifetime. I’m not sure I mastered the art of being diversified, but I am a work in progress. Remember, your diversification will grow though time. You will not start out fully diversified. I continually look at each new investment with the big picture in mind. Will this investment make me more diversified or am I putting more eggs in the same basket?
1) Myself: I was initially a surgeon for 23 years and then changed to a financial coach, author, and speaker.
2) Stock: Various mutual funds and stocks in multiple sectors and countries, both in and out of retirement plans.
3) Businesses: MRI, PET scanner, imaging company, surgery center, candy manufacturing, restaurant, website, and a motel.
4) Real Estate: Single family homes, commercial buildings, apartments, medical buildings, and bare land.
5) Interest Bearing: Certificates of deposit, savings accounts, money market accounts, and real estate loans.
6) Royalties: Three books with another in the making and an on line course.
7) Affiliates: Returns for promoting other people’s courses and businesses.
So how do you feel about your own diversification? How many areas are you diversified in? What has been your strangest investment? Which has made the best return? What has been the most fun to own?