Updated: Jun 15, 2022
As financial investors there is often considerable talk around the topic of diversification. Hold some of ‘X’ asset to provide diversification to your portfolio. Often I find theories that are spoken by parties with an asset class or training product to sell. So I felt I wanted to write a post and work through topic from first principles and how I see it fits into my world and anyone else who is investing to obtain monetary gain / provide financial freedom / a secondary income stream. This is about 15minute read split into several sections.
What is Diversification?
In simple terms the idea of diversification is about owning investment assets / business (asset class from now on in this post) that are independent and not all negatively impacted by the same societal levers. So if you owned two asset classes, when an issue arose that caused one asset class to perform poorly (compared to normal expectations) the same issue would not also negatively impact your other asset class. Therefore you would have a degree of resilience to your income and lifestyle. The more you have an alternative asset class that can fully cover your lifestyle costs the more resilient you become.
For example, say I define I require a £100,000 to live my lifestyle and my property investments only produce £110,000 then any losses above £10,000 will prevent me from living my lifestyle.
Where I have two unconnected income generating asset classes each producing £100,000, then this diversification of income provides me with significant resilience that in the event of a negative loss to either I can still live my lifestyle. If however each asset class only provided £50,000 (£100,000 total) and I required each asset class to fully perform to live my lifestyle, I am not diversified at all.
If you were a residential property investor and you then bought shares to diversify your portfolio but those shares were in a fund invested in residential property, in reality you would have zero diversification, if the fund was in commercial property you may have some diversification depending on the issue you were assuming to protect against.
One of the ideas Ray Dalio is famous for what is termed an “All Weather” fund. Here your investment funds are spread across the 5 core assets classes to minimise the potential downside from one or more of those asset classes dropping 25% or more. Which statistically in the stock market happens at least once every 10 years. Ray devised a method using a balance of risk and probability to say, for example, when gold is performing well then certain share categories won’t be. A key point to remember here when Ray talks of his "All Weather" fund is that there is a team of niche experts investigating and managing each diverse area. Unless your paying for that type of service, one person is not going to get those results. Likely the opposite due to lack of depth of knoweldge. Some investment apps allow you to see major investort portfolios to copy, nice idea but im not sure i would want to spend my time replicating something i didnt understand. You may was well pay for a quality service. A counter is that by using an index track of an exchange you are diversifiying. Hence Warren Buffets advice to just invest in SP500 / FTSE200 index trackers. Low cost low maintenance diversification.
Non Diversification = Singular Focus
The opposite of diversification is singular focus. Here you are all in on a particular asset class and if the income was to drop 25% then you would be 25% poorer unless you then went and found a new investment that could produce or exceed that shortfall.
Returning to the original example, if my lifestyle cost was £100,000 and I have a £200,000 income from a single asset class then I have a buffer zone of £100,000. Effectively I can afford a 50% hit and still live my lifestyle. So I would assess I can probably survive a 1/100 year event. This in many ways to me gives a good argument for using the 10X notions that are currently popular. And being able to live frugally and then be extravagant when you chose and will most enjoy the benefits. When you have a large margin of income above what you require to live then you naturally have a large safety margin, which is all diversification is really. I’ve seen this play, even at a six figure income if you take a £20K hit in one year whilst not being a catastrophe it certainly impacts what you can invest in. So I’m now targeting £250K recurrent income as a baseline because I believe after taxes I can ride out pretty much any bumps in the road ahead.
How to assess what risks to protect against
This is a topic that I rarely see discussed. It doesn’t take much from either uncommon sense or the above two examples that diversification offers benefits. When introduced in the right manner. This to me leads me to the question – what am I diversifying against?
In its simple terms I would have to quantify what types of events have the potential to negatively impact my core asset class. Then have a counter point that would add positively during those times of negativity in my core asset class.
Taking property investing where by income is generated through rental profits. Then the salient events that could have a significant impact on my profit margin would be
· Major repair works – not an asset risk to me, more carrying out regular preventative maintenance within a defined yearly budget. Managing my core asset well should reduce this to a 1/100 year event.
· Tenants unable to pay rent due to a recession – different tenant profiles could counter this issue. Alternatively you want an asset class that will perform well in a recession – but will it then be poor performer in other times that results in an overall negative return?
· Empty properties – no rent income – ensure high quality properties and maintain. A second asset class could protect me here, though I would have to make a risk based assessment on likely drop. For example a HMO landlord may base calculations on 90% occupancy with a worst case scenario of 30% drop. I would then be looking for an income to cover this 30%, a rental guarantee option or other business, or be able to reduce my lifestyle and business costs to counter.
· Strategy becomes redundant – Say Serviced accommodation is no longer required as a local big employer closes who generated 70% of demand. Being a ninja in your area you would most likely have heard warning signs and being looking for solutions. Having SA in other geographic areas within your region would balance this without learning an alternative asset class
When to Diversify?
Ok so let’s imagine that we have identified two events that could prevent our asset class from producing the income required for our lifestyle. The next important component to me is the likelihood of those events occurring. I’m particularly interested in event that could occur in a five to ten year window. The 1/50 or 1/100 year events I want to have an appreciation of and understand what precursors there are to those events. Then as long as I have a safety net and some options I can focus on monitoring the precursors.
Lets take the current Corvid 19 pandemic, a 1/100 year event, there is little I could have pre-empted on that scenario until a few months before. Yes Bill Gates and others had been giving TED talks in the couple of year prior, however there is little I could of done personally. For my property business I wouldn’t have classified that as a big risk other than rents not
being paid. My best hedge against that is good tenants, good properties and then maintaining good working capital to smooth through. Does a pandemic mean I should keep a years operating cash in the bank. Possibly. There is a lot of lost opportunity there however. I would prefer larger volume of tenants that then spreads the risk, particularly if there are several tenant profiles there. Tenants on Universal benefit have shown to be no issue for this scenario in comparison to say hospitality workers. I recently read that only 4 or 5 companies in US were around from the 1770s, one being JP Morgan Chase. So clearly long term there may be issues with any asset class when looking ten years or longer into the future.
Considering five to ten year events is more sudden issues or society changes. For example you may be invested in student accommodation and due to the Corvid 19 pandemic, changing job market, corporate investors, or teaching moving online the outlook for student rentals in your area may be to fall by 10% year on year. I don’t class this as diversification issue. Here we are looking at a complete change in strategy due to future market changes. The way to protect for the downside here is expert knowledge in your field and not getting caught up in bullish media stories. Reviewing the market and your position within the market. So if you believe there is going to be a long-term change which will reduce your ability to perform you can pivot out of the market, while the outlook is still potentially good to an amateur, and go into a new niche. Viewing small investments into various alternative asset classes as a counter to this risk wouldn’t be very prudent.
Diversify to Increase wealth
This is another theme that seems to come up in investors that look at other asset classes to provide further wealth. Potentially more risky but maybe higher rewards than their core asset class. At times we get attracted by this shiny ball.
Taking a step back and considering the notions of compounding and exponential growth within the real world, it is to me significantly easier to go from say £X income in one asset class and grow that to another multiple of that value. You are in simple terms repeating what you already know either on large scale or greater quantities. This concept is exactly the same when you grow your knowledge in a core area. This is maximising the return on your existing knowledge and skill, and further evolving it as the social climate evolves. In comparison to the effort required to go from 0 to £100,000 in a new asset class. Where you have to learn from zero and make all the mistakes necessary to become a ninja at it.
A common quote that I see stated in meme / fake guru posts etc is that multi-millionaires have on average six streams of income. The insinuation is therefore that if you want to be the same then you must have 6 streams of income. The devil is always in the detail and I can with almost certainty say that any millionaire / financially independent person I have reviewed got to that position by singular focus on one idea / business / asset class. Only then when they were an absolute ninja at that topic (where it could continue in semi automation) did they start adding other streams of income. Typically those streams will be compounding the knowledge they have learnt in their primary area or have funded them alongside their core area due to excess cash flow.
A funny property example here is in the UK the footballer Robbie Fowler played for Liverpool in the 1990s and away team fans often use to sing a comedy chant at the Liverpool supporters of “we all live in a Robbie Fowler house, a Robbie Fowler house”, to the melody of The Beatles – Yellow Submarine. This is an example of good diversification. Robbie was likely earning circa £20K+ a week as star footballer. He continued that focus but through his management company (doing the leg work) invested a lot of that mon
ey into buying cheap terraced houses in Liverpool. He could certainly have been buying one a week based on house prices at that time. He almost certainly employed an expert in that asset class to do the work while he maintained his football skills and generated large cash flows. This is using singular focus to become rich and at a point using the excess cashflow to then invest in an unconnected secondary asset class to further grow your wealth. Robbie now offers a property training school thus stacking a new business onto the property rental side. This is the usual reality of rich people having multiple businesses. They grow out of a very successful cores business that at least for part of the time was continued and funded the diversification.
Having considered the various facets of diversifying investments and what that means for most investors I reached the following conclusions
a) Focus - Don’t consider diversification until you have become a ninja in a single investment asset class which produces an income in significant excess of that which allows you financial freedom and to live your lifestyle. Singular focus wins the race everytime. Diversification before then is just wasting energy. There are always shiny balls to chase if you wish to look for them.
b) Understand Your Risks - To truly have diversification then identify the biggest and most likely to occur risks to your core strategy. Understand what the impact could be and how it will play out if it occurred.
c) Establish and then invest in an asset class that will counter those risks. Again I would look to limit my diversification to just a second asset class, learn it and build it up until it rivalled my core strategy.
d) Seek Exponential Growth - Spreading money across various asset classes that you don’t understand, or are of insignificant values to counter a loss to your core asset class, is a waste of energy and opportunity. Invest the money in your core strategy and compound your expertise.
e) Cash is king - The simplest hedge is to hold sufficient quantities of cash or a very liquid asset that will grow with inflation, to cover 3 to 6 months income. At very least this would buy time to pivot or ride out some bumps.
f) Slow and steady wins the race every time. Almost no one becomes wealthy quickly. Other than selling drugs or other illegal schemes. It’s the ten years to be an overnight success jazz.
I would love to hear other investors stories and take on diversification. This is just mine and I’m happy to stress test it so we all can learn and move forward…
Thanks for reading. A