Personal Finance

How Much Investment Diversification Is Right for You?

Expertise: Real Estate Investing Basics, Real Estate News & Commentary, Flipping Houses, Mortgages & Creative Financing
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With the economy and markets getting more volatile and a lot of investors growing skittish, I’m starting to hear more talk about the importance of diversifying investments. I hear many people referring to diversification as the key to long-term investment survival and success.

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But the more I discuss diversification with people, the more I realize that most of us haven’t put a lot of thought into the topic.

Yes, diversification reduces risk. There’s no argument there. In fact, that’s the single biggest goal and benefit of diversification—reducing exposure to risk.

But does that mean we should all diversify our investment portfolio? And if so, how much diversification is the right amount?

Related: Why Diversification (of Your Portfolio, Financing & Everything Else) Truly is the Only Free Lunch

stocks, assets, diversification, allocation

Finding the Sweet Spot of Diversification

Good investors and business owners think about diversification as an insurance policy.

Essentially, it is. It’s an insurance policy for your portfolio.

So, let’s replace “diversification” in the question above with “insurance.” Do we all need insurance? If so, how much is the right amount?

When we think of it in these terms, the answer is obviously, “It depends.”

Remember, just like with an insurance policy, there is one major downside to diversification: It’s not free.

Diversification will cost you money in terms of reduced returns. If I diversify my investments into five different asset classes, it’s unlikely they will all perform equally. Some will generate higher returns than others. And the lower-return asset classes will bring down the average returns that the higher-return asset classes provide.

But that’s the trade-off we make in order to reduce our overall risk. Just like we shell out cash every year for an insurance policy that we may or may not need, it protects us in case something DOES go wrong.

Related: Real Estate Is Crucial to Your Investment Portfolio: Here’s Why

investing, diversification, assets, allocation

Determining When Diversification Is Necessary

Now that we’re thinking of diversification like an insurance policy, let’s consider when it’s needed and to what degree.

Diversification is necessary:

When we have other people depending on us, we can’t afford to subject them to the risk of losing everything.

Most of us think about life insurance when we’re married and have minor kids. But when it’s just us, there’s less concern about dying. This holds true in our business and investments, as well. If other people are depending on us to not allow our businesses to “die,” diversification is a lot more important.

When we’re knowledgeable and diligent about staying healthy, our risk is lower.

Health insurance is much less important for those who understand how to keep their body in good shape and actively work at it. If I understand the basics of nutrition and I work out every day, I may be able to save some money by having a high-deductible health insurance policy—or perhaps no policy at all.

Likewise, if we understand what makes a good/bad investment and we work hard to keep our investments on track, diversification is much less important. Our risk is inherently lower.

When we get older, we need to be more cautious.

Someone who loses everything at 25 has decades to rebuild their portfolio and plan for retirement. Someone who is 55 doesn’t have the same luxury. As we age, diversification becomes more important simply because we don’t have the time to rebuild should we lose it all.

When we have less control, we need more protection.

Firefighters, police officers, and soldiers all face risks that are out of their control. For that reason, they better make sure they’re paid up on their insurance. On the other hand, accountants, computer programmers, and cashiers have a lot more control over the risks to which they are exposed, so insurance is less of a necessity.

Likewise, investors who have more control over their investments are less in need of diversification. If you invest in the stock market, where you have essentially no say in the decisions made by the companies in which you invest, you're probably going to want your portfolio to be highly diversified. But if you self-manage rentals, you may have enough insight and control over your investments that diversification isn't needed.

Each of us needs to evaluate our personal and financial situations, our investments, and our businesses individually in order to decide what amount of diversification is right for us. Understanding that diversification is simply an insurance policy for our portfolio can provide an appropriate framework to help determine the right trade-off between risk and reward.

What’s your diversification strategy? And why?

Comment below!

By J Scott
J Scott runs a real estate company that invests in several parts of the country and that specializes in new construction, as well as purchasing, rehabbing and reselling distressed properties. J is ...
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    James Free Rental Property Investor from Fort Collins, CO
    Replied over 1 year ago
    Diversification is a means to an end. The end is risk-mitigation. But there are other forms of risk-mitigation. If all of your money is in annuities or bonds, you’re incredibly safe. Yet someone out there will tell you that you lack diversification! I like Jay’s main points about thinking about the degree of “diversification” that you need. I’d further add that even a VSTAX investor isn’t as safe as many real estate investors because of the higher floor of real estate and the fact that stock momentum tends to span all stocks. Owning Coca Cola AND Pepsi protects you from a scandal at one of the two, but not from a general trend away from soft drinks! Fortunately, real estate is local. Really local. Even owning in different parts of the same large city can protect you from a lot of regional issues. What if the overall economy tanks? Well, then all your assets might lose value, but will rentals fall more than stock? Unlikely!
    Michinori Kaneko Rental Property Investor from New York
    Replied over 1 year ago
    i disagree, if your money is in a single bond or annuity you are NOT safe. how do you know the bond issuer or annuity payer will not default or go out of business? With how things are, even the US Govt can default. there are few types or risk, and you need to always be aware of “counterparty risks.” You are only comparing stock with Rentals. Sure, when there is an economical downturn the stocks value will fall more than housing (maybe, depends on location e.g. Detroit). but when the economy is doing well stock will rise more than housing value in most areas, (places like NY, San Fran are exceptions). Rentals provide slightly more stable returns because you can still rent during the economical downturns, you may still get income from rent if your properties don’t go vacant. but you also don’t have to sell your stocks when the market is down and just hold it until it goes back up. sure there’s no cashflow there, but you also have no expenses for just keeping the stocks (unlike with real estate, whether or not you have a tenant you still have certain expenses like taxes, insurance, maintenance). Another good thing about stock investing is you don’t get taxed until you sell (or receive dividends), where as with rental you get taxed every year on your income (with some deduction, which is nice). Thus, with stocks you get to retain more of your upside without paying portion of it to Uncle Sam. I want to note i’m not anti Real estate (in fact i’m a big fan and I am a REI). But there are other risks too, like “regulation risk”. How do we know that the government will not change the law on rentals to increase taxes on it or make it less favorable one day (or change law on stock gains to become more favorable)? The best way to truly diversify is across asset classes and diversify even within the asset class. this means, have some real estate, stock, and other investment type and don’t just invest in one type. this is true meaning of diversification and risk mitigation in every aspect of risk.
    Luke Ski from Columbia, Maryland
    Replied over 1 year ago
    Well, I get the part that we are all investors and we do invest in things to make money. Maybe I am the only one here who believes that economy is slowing down and will get even worse within next 2 years but?! I live in Maryland and can tell you that the amount of properties left to make good profit of,nowadays is near zero. Prices are stupid high, interest rates are getting there too. Why do we need to feel forced to keep buying properties and stock when the time is just garbage ??! What I propose instead ? Well, pay off the mortgages you have , or build up your cash kingdom and wait for prices to dip in a year or two … or three. Who cares when, just be patient and you will buy more properties later than today. As far as stock goes …. what diversification? Sell all you can while prices are high ( which is now ) and buy them cheap later. FYI, no , I am not a Nostradamus, but if it walks like a duck and sounds like a duck …. U.S economy is about to slow down rather sooner than later and y’all know it. Greetings my patient friends 🙂
    J Scott Developer from Sarasota, FL
    Replied over 1 year ago
    Hey Luke – I think perhaps you misinterpreted what I wrote. I didn’t make any recommendations on whether people should be investing or not investing right, or in what assets. My point was that when you DO invest, the level of diversification needed is going to change based on your situation. I see nothing wrong with not investing in asset classes that you don’t believe you can make a reasonable return. If you can’t find good flip deals, you shouldn’t be investing in flips; if you can’t find good rentals, don’t buy rentals. Only do what you’re comfortable doing. Now, all that said, there are still asset classes within real estate where you can make good returns right now — they just may not be the strategies you’re interested in or good at.
    Scott Beal Financial Advisor from Omaha, NE
    Replied over 1 year ago
    I agree, diversification like insurance is situational dependent and at its core a personal decision. I like to think of insurance as a transfer of risk. If one doesn’t have the resources to survive a cataclysmic event (fire, flood, total my car, major health) they buy a policy and transfer that risk to an insurance company. On the other hand, if one has multiple sources of income, different assets and sufficient cash one could in some cases self insure. To Scott’s point, it’s personal. Scott nailed the relationship of risk relative to age and time. And while many will grow more conservative over time and reduce their risk through diversification it’s not a universal law. Again, it’s personal. Financially speaking a 65 year old with assets to provide a steady income may able sustain a 20%- 50% drop in the market (RE or Stock) without impacting their income. At the same time a 25 year old may be able recover from a total loss. Both could be fine financially speaking but would they feel fine? Could they emotionally manage the risk?
    Russell Wagner
    Replied 8 months ago
    J Scott - great post. I am heavily a believer in the stock market, but I started my BP journey purely for cash flow. Apple had a great Holiday, and yes their earnings are up but I cannot time when it will go down. So instead of investing in companies, now I am investing in people/tenants and trying to buy habitual properties that have consistent tenants. Here is my thought, if the stock market does have a down turn I am not reliant on the earnings of the companies in my retirement but instead the continual flow of rental income. This way wherever the market goes up or down, I have my home built diy annuity. Psyched to listen to your business podcast have, will be a newbie on that.