This blog is my introductory blog on why financial diversification is the key to managing risk and growing wealth.
What is Diversification? Diversification is investing across multiple assets to reduce exposure to any one particular asset. Generally, if one asset class goes down, there are usually other asset classes that go up.
Most Americans generally invest in equity markets (Stocks) and fixed income (Bonds) as part of saving for retirement or wealth appreciation or both. I too was this way for decades, until I started understanding better about diversification after I read several books, attended seminars and listened to countless podcasts.
As part of the diversification, one needs to consider beyond just stocks and bonds. There are many asset classes available for investing such as real estate, alternative assets such as crypto, hedge funds, private equity and so on. One can truly diversify regardless of the income or portfolio.
So how should one approach and create diversification across the different asset classes? Please note that diversification is not one size fits all, but should be highly customizable and adaptable. This depends on multiple factors including income, current age, net worth, planned retirement age and so on.
While there is not a single platform for diversification, one can invest through multiple platforms available online to achieve the diversification
The diversification should be across the below four categories:
- Equities (Individual Stocks, Index funds, ETFs)
- Fixed Income (Bonds)
- Real Estate
- Alternative Assets
Equities (Stocks or Stock Funds)
Stocks is one of the oldest asset classes and is the most well known asset other than real estate. Going back in history, stock trading started over 400 yrs ago.
So what is Stock? It is a type of security that gives stockholders a small portion of ownership in a company. Stocks also are called “equities.”
We generally invest in equities through our retirement accounts or directly on platforms such as E*Trade. One can invest in either stocks or can invest in stock indexes.
What is an Index? An index is a group or basket of securities or derivatives that represents and measures the performance of a specific market, asset class, market sector. In other words, indexes are collections of stocks based on the size of the company, industry, geography and so on. ETF are indexes which are traded in real time like stocks.
Index funds perform better than individual stocks 96% of the time. Some individual stock traders claim that they can beat the market but the facts indicate the contrary. Market gurus such as Warren Buffet and Ray Dalio with decades of expertise and experience with thousands of analysts in their staff can beat the market. An average investor neither has the expertise or experience to pick individual stocks to beat the market.
There are new generation online platforms such as Betterment in the last 10–15 yrs to invest in index funds (both stock and bond funds). The platform selects indexes based on your risk tolerance and at a low fee (0.25%) compared to traditional companies which charge considerably much higher (1–2%) for equal service.
Fixed Income (Bonds)
Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.
Bonds provide fixed income regardless of the market conditions. This provides a cushion to stock markets which can be very volatile. The income generated from Bonds can be redistributed to buy more bonds or equities.
Note that real estate is not a single asset class. There are several asset classes within real estate such as single-family, small multifamily 2–5 units, multifamily (>5 units), land, mobile homes, storage, industrial, commercial (Retail, Office, Industrial, etc). Note that I am not referring to owning a primary home when I mention real estate investing.
One does not need a fortune to invest in real estate. One can invest in real estate directly or indirectly through REIT (Real Estate Investment Trust), which trades real estate like stocks. One can invest in real estate directly with smaller capital with companies like Yieldstreet. With higher capital, you can invest in syndication for larger real estate property (Industrial, Retail, Multifamily).
It is a well known fact that multi millionaires (High Net worth Investors aka HNIs) do invest disproportionately in real estate. For more than 200 years, investing in real estate has been the most popular asset class for HNIs to grow their wealth.
While this asset class is most speculative, this category can provide the most opportunity for growth. The category includes gold, commodities, rare paintings and crypto. Note that alternative assets generally do not produce case flow but are expected to appreciate over time. While crypto is currently going through major correction driven by exuberance and greed, it may stabilize over time and will have a role to play globally just like currency and also as asset. One can invest in crypto very easily through online platforms or apps such as Robinhood, Coinbase.
Diversification across various asset classes
So what should be diversification across each of the asset classes? While there is no formula for this, my guidelines are documented in the below table. By investing close to these numbers across multiple asset classes, there is higher potential for growth in the long term while lowering the risk.
Category 1 is recommended for individuals who are younger, low to middle income, new to investments. Category 2 is recommended for individuals with higher income, higher net worth, and experienced investors.
When one combines a good diversification strategy with patience, one can minimize the risk and achieve growth over the long term.
My next blog will cover how the average American can also invest and grow their wealth like the Rich do.
Disclaimer: I am not a certified financial advisor. This should not be considered as professional advice. All investments including real estate have market risk due to macro and micro factors.
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