In asset allocation, diversification is a hedge against risk. Putting 100% of your money in one stock is extremely risky due to the volatility of an individual stock. A single stock is subject to 5 types of risk: Business Risk (earnings could drop), Financial Risk (the company can’t get funding), Liquidity Risk (you can’t sell it), Exchange Rate Risk (the Yen drops suddenly), and Political Risk (your Italian stock plummets due to an unstable economy). By owning multiple stocks, and asset classes, you reduce the risk without necessarily dropping overall returns. It’s a no-brainer. To learn more about the statistics, I recommend The Intelligent Asset Allocator by William Bernstein.
Wouldn’t it also be wise to diversify your income? First, let’s define the risks that pertain to standard income (your job):
- Performance Risk – Poor performance resulting in job loss or demotion
- Management Risk 1 – Poor management led to bad decisions, earnings loss, layoffs
- Management Risk 2 – Manager doesn’t like you, demotion, bonus loss, job loss
- Sector Risk – People no longer want the widget you create
- Economical Risk – Economy drops due to high unemployment, high national debt leading to less buying and less earning
The overall risk is the product of these 5 risks. Your risk volatility is maximized when your income is single sourced. Let’s look at my income diversification, as a percentage of my monthly spending:
One final alternative is to get a second job working part time in the evening or weekend. This is not worthwhile for me, as my savings rate is already very high and my family time is more important.
Mine is not a great diversification, but it’s a start. If I were to lose my job today, I would benefit by this diversification in two ways. First, I would be receiving a passive income of 51.5% of my expenses. Because of this, my savings would last twice as long as it would otherwise. In my case, I speculate that to be about 35 years. I would benefit further because I’m already in the door on these other incomes, making it easier to grow them if I needed to. As an example, I could more easily raise my online business from 17% to 50% than I could starting from scratch and getting it up to even 10%. The startup is the hardest part – building skills in web design, SEO, market research, accounting, etc. Same goes for dividend stocks, I’ve done the research and know how to evaluate a stock. Had I not begun that investment, I’d need time to learn and build confidence, not to mention take advantage of dollar cost averaging during my initial buy-in.
My goal is to have a non-job income of 70% my expenses by the end of the year, and 100% by the end of next year. Once i reach 100%, I can’t retire immediately because that will once again leave me undiversified. However, once I get some buffer above 100% or by raising my other streams of income higher, I can then safely retire.
How are you all diversified? Have you done an allocation analysis like mine?