The ‘Experts’ Are Wrong About Diversification
You’ve probably heard a financial planner preach about the importance of a “diversified portfolio” at some point — but what exactly is their definition of diversification?
As Warren Buffett says, “Diversification is a protection against ignorance. Diversification is not required if a person knows what they are doing.”
People who seek security use the word “diversification” a lot. Why? Because the strategy of diversification is an investment strategy for “not losing.” It’s not an investment strategy for winning. Successful or rich investors don’t diversify. They focus their efforts.
Warren Buffett doesn’t diversify. He focuses. He looks for a great business at a great price. He doesn’t buy a lot of businesses and pray one of them does well. He doesn’t want average returns, or to play the stock market. He likes to control the company, but not run the company. When Buffett talks about investing, his keywords are intrinsic value, not diversification.
One reason financial advisors recommend diversification is that they cannot find great companies. They don’t have control, and most don’t know how to run a business. They are employees, not entrepreneurs like Warren Buffett.
When most financial planners and advisers tell you to have a diversified portfolio, they are usually referring just to your stock portfolio. Diversification to them means investing across the various stock sectors, such as large-cap, small-cap, blended, blue-chip, high tech, or alternative energy.
But here’s a little hint: To truly be diversified means to diversify beyond paper assets, across all asset classes.
The Five Primary Asset Classes
While there are many assets you can choose to invest in, the five primary asset classes are:
If you are considering starting a business, then you can use your own money, raise money from private individuals or borrow money from a traditional lender to get started. The purpose of the money you invest, no matter where it comes from, is to generate a return on that investment — which will go back to you, the business, and your investors, and/or lender.
Now, let’s say a friend comes to you seeking an investment in his/her business idea or gives you a hot tip on an investment they are making in someone else’s business. You may choose to invest in this private business or company — after first doing your due diligence to determine if the opportunity is right for you, of course. Since the business and the owners may or may not be familiar to you, you’ll need to do your homework on:
- The project (the business itself),
- The partners,
- The financing, and
- The business and management team.
There are two main reasons to invest in real estate: cash flow from rental properties and capital gains when you buy and sell (flip) properties. I invest primarily in rental real estate because cash flow fits my formula for financial independence. You’ll decide which model works best for your goals and situation.
Real estate investing is not a one-size-fits-all solution. There are many investment options when it comes to this asset class: single-family, duplex, triplex, apartment buildings, office buildings, retail strip malls and shopping centers, and industrial properties such as warehouses, hotels, and mobile-home parks.
It’s best to start small in the beginning, but the sky’s the limit — maybe someday you’ll own a skyscraper!
One of the biggest benefits of real estate is the concept of leverage. Leverage is the ability to use OPM (or Other People’s Money) to purchase the asset. A property that is highly leveraged means there is a lot of debt on the property compared to equity (equity means the current market value minus the debt.)
A property that has a debt of 90% (which means the owners and investors put down 10%) is more highly leveraged than a property that borrowed 70% and put 30% cash into it. The higher the debt on the property, the lower the cash flow. The lower the debt, the higher the cash flow.
Most people are already familiar with traditional paper assets, which include stocks, bonds, mutual funds, and retirement accounts.
You can also invest in stock options, stock futures, and foreign exchange.
Paper assets include REITs (real estate investment trusts), which are funds that only invest in real estate.
You can also consider ETFs (exchange-traded funds).
This asset class is typically capital-gains investments (versus cash flow). However, stock dividends, which are effectively a source of cash flow. Once you learn the language of paper assets, you can jump right into investing.
The next asset class is commodities — metals such as gold, silver, and copper; food such as grains, corn, coffee, and sugar; and raw materials such as oil, gas, and cotton.
The price of commodities is typically driven by supply and demand. If there is a bumper year of corn, then prices are low since the supply of corn is high. If, on the other hand, there is a shortage of corn due to drought and unfavorable weather conditions, then the price of corn will be high.
You can also buy what are called future contracts of any commodity through the futures exchanges.
The final asset class is cryptocurrency, a decentralized digital currency that you can buy, sell or exchange directly — and it’s not backed by the government or any issuing institution.
It seems everyone is talking about digital currencies like Bitcoin, Ethereum, Tron, and Litecoin (there are more than 5,000 cryptocurrencies in existence today) these days. And why not? With massive fluctuations in value and short-term gains in the 1,000% range, it’s very exciting and enticing stuff.
Some people are turning to bitcoin and other cryptocurrencies as an alternative investment, helping to diversify their portfolio. There are two main types of investors: those who buy and hold it long term and those who buy and sell after a price rally.
If you haven’t done your due diligence, there’s a potentially dangerous side to the game of cryptocurrency. How so? There’s an unfortunate list of would-be crypto-millionaires who lost their passwords and got locked out of their own fortunes. Including the man who owns $321 million in bitcoin, but can’t access it.
Ouch. Also, there are unpredictable crashes, just like with the stock market.
Another word of caution, while I’m at it: it does not put money in your pocket. Because it’s exploding in value, many people feel rich, but they are not. Bitcoin and other cryptocurrencies are not useful for commerce, so the only way to realize value is to sell. Only then, if you make a profit, do they become an asset.
Now’s the Time to Diversify
The stage is set for great economic upheaval. Such upheavals have always marked the end of an old era and the birth of a new one. At the end of every era, some people move forward, and other people cling to ideas of the past.
I’m afraid that people who still believe their financial security is the responsibility of a big company or big government will be disappointed in the coming years. Those are ideas of the Industrial Age, not the Information Age.
No one has a crystal ball. I subscribe to many investment news services and each one says something different. Some say the near future is bright. Some say a market crash and major depression are right around the corner.
I think we must also focus on our long-term financial security and not leave that responsibility to a company or the government.
To remain objective, I listen to both sides, because both have points worth listening to. I do not play fortune-teller, trying to predict the future. Instead, I work at staying educated and being prepared for whatever happens.
A prepared person will prosper no matter which direction the economy goes, whenever it goes.
Editor, Rich Dad Poor Dad Daily