Can diversification reduce risk?
A proverb advises against putting all of our eggs in one basket. Andrew Carnegie advises us to put all of our eggs in one basket and then watch it. Both of these can be considered good advice. The proponents of diversification advocate the more diverse a portfolio, the less risk from each of its components.
This argument makes logical sense on the surface but really needs to be explored in the context of your individual plan.
There are countless ways to achieve Financial Independence. You chose one way – your way.
You strive to be the expert of your strategy. You may focus on stocks or real estate. You may start your own business. In all likelihood you’ll combine any or all of these asset types to reach Financial Independence. But, if you choose specialization and focus on a single method to reach Financial Independence, you’ll still have to deal with risk.
There are varying levels of diversification and strategies to mitigate risks.
For example, the portfolio of a real estate investor may include only single-family properties in their hometown and another might include single-family, multi-unit, and commercial properties in multiple states.
In the realm of stocks, the portfolio containing only a single tech company stock isn’t diversified compared to a portfolio using passive index fund investing in broad stock market index funds such as Vanguard’s VTSAX or Fidelity’s FSTVX. One would be even more diversified if they added international stocks or bonds to their portfolio.
Practically, our level of diversification becomes a result of our basing investment decisions on our unique circumstances including our understanding of, and appetite for, risk.
As people assertively pursuing Financial Independence, we are likely to be less concerned with the term diversification than we are with the general term risk. With a little research, we can determine for ourselves if a specific investment fits our personal risk profile.
Mitigating the downside risk of any decision should always be considered.
The Financial Independence of a person investing in single-family rental properties in one location may or may not be at any more risk than the Financial Independence of someone who focuses on investing only in a single broad market index fund. Various techniques used under each strategy can lead to success.
A question to focus on is, “Based on everything I understand at this point in time, does my chosen strategy have a high probability of being successful?” If the answer is yes, you are in good shape. If the answer is no or you are unsure, then spend some time learning and speaking with others along their FI journey who have successfully incorporated similar strategies. This will develop competence and confidence. You will then modify your plan as appropriate to increase the likelihood of success.
An increase in understanding of successful strategies will lead to selecting a strategy, simple or intricate. When ready, take action, monitor progress, and make adjustments when necessary. This journey is dynamic and things will absolutely change over time.
You will build relationships with other smart people who “get it” and they will add value to whatever strategy you’ve chosen. Other factors will increase or lessen the risk of you reaching your FI goals as planned. You may change jobs that increase or decrease the amount of money you are able to invest. If you own a home, it may appreciate or depreciate significantly, introducing opportunities or challenges to consider.
“Risk comes from not knowing what you’re doing.” – Warren Buffett
You are the ultimate authority of your money decisions and executing your strategy to reach Financial Independence. An optimistic questioning attitude will lead to increased knowledge about various asset classes such as real estate, stocks, bonds, and business. You’ll cultivate a willingness to consider integrating new approaches into your plan. During this process, risk will become a constant consideration and your portfolio will reflect that.
- 8 Things That You Need to Know About Risk Management by Brian Beattie of volarisgroup.com
- 15 Ways To Manage Risk In Your Financial Life by Silicon Valley Blogger of wisebread.com
- WANT TO BE MORE SUCCESSFUL IN YOUR LIFE? TAKE SOME RISKS! by Pauline Paquin of reachfinancialindependence.com
- Three Simple, Fun and Effective Tools to Help Manage Risk by Will Gadd of TedX Talks on YouTube
- List 3 potential risks in your current FI plan – share below in the comment section if you’d like. Think of ways you can eliminate or mitigate these risks. If you are not sure on how to eliminate or mitigate the identified risks, conduct the necessary research to build your competence and confidence. Implement the changes and continuously monitor to identify potential risks in your strategy and techniques.
- Is Risk Management The Same As Timing The Market? by Doc G of diversefi.com
- Diversifying Your Portfolio at finra.org
“There are risks and costs to action. But they are far less than the long range risks of comfortable inaction.” – John F. Kennedy