where diversification meets net worth
You've heard a million times about diversifying your investment portfolio. The idea of not putting all of your eggs in one basket by diversifying across a number of stocks or mutual funds, and then further
diversifying across asset classes by owning things like bonds, cash or commodities. That's all fine and good for your investment portfolio(s), but it fails to ignore the big picture of your entire financial net worth. Where is the majority of your wealth and what risks does it create for your financial future? Diversifying your financial net worth as opposed to just your investment portfolio can reduce risk and maybe improve returns.
What is financial net worth?
First of all, on this site we use the term financial net worth, not net worth. Your net worth implies your value as a human being and financial net worth is your financial value. There's a huge difference, and we shouldn't confuse the two. Although we take money seriously on this site, at the end of the day money is just money and doesn't define our personal value.
Back to financial net worth. In basic terms it's the value of all of your assets minus all of your liabilities. So, a stock is an asset but a loan you need to payoff is a liability. For houses and cars you take the value of the asset minus the amount you owe on it to see how much it's contributing to your financial net worth. In my calculation of financial net worth, I exclude cars altogether because they're a drain on your finances and shouldn't even count in any measure of wealth.
Why is financial net worth diversity important?
Most people building wealth rely on their investment accounts (401(k)s, IRAs, brokerage accounts, etc..). This isn't a bad idea since over time these are good places to build wealth with their tax advantages (at least for retirement accounts) and broad range of investment options. Most people should absolutely invest as much as they can in these accounts. As these accounts grow, people find themselves with a decent pile of financial assets (usually stocks and bonds), but in many cases no other assets.
So what's the risk?
As our investment accounts grow, a larger percent of our financial net worth is tied to the performance
of the financial markets. Look at where things stand today in early 2018. While none of us know where the financial markets are going (and anyone that tells you they do is lying), there are certainly risks building in financial assets. Stocks have been running up so far for so long that there may be a
correction coming. Bonds prices tend to drop as interest rates rise, which the Fed has indicated is likely to happen in 2018. So financial assets could be in for a down period in the near future and if that's the only place you keep your wealth, you're looking downward as well.
Let's see some examples
Let's say Sue has built up investment accounts worth $200,000. She has these investments in a variety of mutual funds that invest in stocks and bonds. They're great investments, but they're all she has. She rents an apartment and has no other significant assets. If a financial market correction decreased asset values by 25% this year, not only would her investment accounts decrease by a similar amount, it would represent a decrease to her entire financial net worth.
Lisa has built up investment accounts of $80,000, also in mutual funds. Additionally she owns a house and has about $70,000 in home equity. She also has a stake in her friend's restaurant business worth $10,000, and a small piece of land upstate worth $40,000. In total, her financial net worth is also $200,000. The difference here is that Lisa has financial net worth diversity. So if there's a 25% correction in financial markets, she may lose about $20,000 in mutual fund value, but her other assets may not be affected. Perhaps real estate values continue to increase and her friend's restaurant business really begins to takeoff, offsetting her financial losses or even increasing her net worth.
These are, of course, just examples, but there's a very important lesson here. If we believe diversification is critical to a successful investing strategy, why stop with just our investment accounts? Shouldn't our finances be diversified when viewed holistically? Some would disagree and argue that there are better returns in financial markets than anywhere else and we shouldn't invest anywhere else. I know just as many people that would claim returns on rental real estate are the best way to go. The point here is not to argue over which investments are the best, only that we should apply our risk mitigation techniques to our whole portfolio of assets.
So what to do about it? There are many different ways to build wealth. Merely owning a home will build real estate equity as you make payments on your mortgage, even if the house doesn't increase in value. Talk to a professional to learn the pros and cons of each, but people build wealth through many means, including;
Real estate (owning your own home, rental real estate, REITs)
Small business investments
As always, think about what makes the most sense to you. Doing so will set us up for a smoother ride and reduce the chance of losing a large portion of our wealth when you're approaching a critical finish line, like retirement. Do you have additional ideas for diversification? Do you apply these strategies to your finances? Tell us about in the comments section or contact us.
Disclaimer: 8th Great Wonder is not certified to recommend specific investments. Before making specific investments, consider talking to a professional.