Personal finance guru Ramit Sethi recently posed the question on his blog: How much should one asset represent in your net worth? His question is rooted in the topic of diversification, something often discussed as the foundation to a well-balanced portfolio. The reality is that most people have varying definitions of diversification and do not recognize its value beyond a portfolio allocation. Stepping back and evaluating the true meaning and impact of diversification can hugely benefit your overall financial position.
Simply put, diversification is the act of spreading your risk exposure across multiple investments. Most commonly we use asset classes to divide the investment market into various segments. Examples include growth stocks, value stocks, small-cap stocks, and bonds. By allocating your investment portfolio to various asset classes, you gain more stability and have a greater chance for long-term growth. If one segment underperforms, the negative impact is minimized. You also have the chance to participate in the growth of another sector to offset its loss. A diversified investment allocation is crucial to the success of your portfolio (you can read more about that here), but what about the rest?
While diversification in your investment portfolio is a well-known and widely practiced concept, it often stops there. What is missing? All the other moving pieces of your financial plan! For instance, if you are an income earner – where is your income being generated? Is it concentrated in full-time work for one company? Do you own your own business that fully supports your livelihood? For many of us, our income is one of our biggest assets, so it should certainly be included in this conversation.
If you are a full-time employee, perhaps you should consider investing away from the company that pays your salary. Some companies may offer stock options to their employees and this is an opportunity to carefully consider. Since your paycheck is fully vested in the company’s success, does it make sense to allocate your investment dollars to this company as well? If your employer fails, you will not only lose your job but also your investment performance will suffer.
Similarly, if you own your own business it is wise to build an investment plan outside of your company. Have you considered this? It can be risky for your business to represent a significant portion of your net worth. How can you diversify and reduce your risk exposure? High concentration in one company, asset, industry, or investment type can lead to extreme volatility and heightened stress.
Correct application of diversification is hugely important, and there are a lot of ways investors apply this concept incorrectly. Some people think that diversification means spreading their money out across several vendors. Most of the time this only creates more administrative headache with little or no gain. Other people will have numerous accounts of the same type that are earmarked for very specific goals. Oftentimes this results in more paperwork, more confusion, and more complexity when a simpler solution is available.
Instead, I implore you to think outside of the box and consider how your net worth is allocated. Does one company, one real estate holding, or one industry represent much of your net worth? Have you fully considered the risk you are accepting by the investment decisions you are making? Is there a simple way that you can diversify away some of that risk?
By now, you have formed an answer to Ramit’s question. How much should one asset represent in your net worth? Setting personal rules of tolerance for asset class concentration is an important part of building your financial plan. What are you comfortable with? After review, are there changes you should make today to better reflect that answer? Once you understand that diversification goes well beyond your investment portfolio, you can form a plan to reduce your risk and reach your goals.