Everywhere you turn for money news, all you hear about is diversification. The so-called Wall Street experts tell you that diversifying is an absolute must for protecting your portfolio.
Smart investors know better. The ultra-wealthy don’t diversify in the Wall Street sense of the word. In my article “Investment Diversification Gone Wrong,” I do a deep dive into this.
The ultra-wealthy don’t play the Wall Street diversification game because you also reduce returns by minimizing risk through diversification. An S&P 500 index fund is meant to offer investors hands-free diversification through spreading the risk over a wide swath of industries. Like the Dow, the S&P 500 gives investors insight into the “average” performance of the market.
Many investors fail to grasp that the best that you can do is average by diversification. The ultra-wealthy didn’t get to where they were at by aiming for average. I’ll repeat two of my favorite quotes from my previous article:
“Diversification is for idiots.” -Mark Cuban.
“Diversification is a protection against ignorance . . . makes very little sense for those who know what they’re doing.” -Warren Buffett.
Diversification is playing not to lose, and it’s not a great strategy when the whole market collapses. Few industries are spared in a crash. The same goes for diversified portfolios and funds. Ultra-wealthy investors don’t diversify because they aren’t playing to lose. They play to win by building on the lead. They’re not content to sit back.
What do I mean by building on a lead?
While the average investor “hopes” their portfolio grows through some luck, the ultra-wealthy take proactive steps to build wealth, and the big differentiator is where they decide to diversify.
The average investor sets aside savings from the income they earn from their job and hopes to grow their nest egg through a portfolio of stocks. Their hope is to earn a return on their investment solely through appreciation. The problem with this approach is that if the market crashes right before they plan to retire, their nest egg might not be as big as they had hoped. This happened to many imminent retirees in 2008 when many saw their 401(k) wiped out overnight.
If you’re a potential retiree and your diversified 401(k) is wiped out, how do you make up for lost income? If you only have one job and one source of income, you can’t. Many retirees cannot keep working physically, and social security isn’t going to cut it.
How do retirees pay their bills now if their retirement savings won’t cut it and there’s no other source of funds to tap into? That’s the predicament many Baby Boomers currently face as they reach retirement. The majority don’t have enough savings to get them through. But they did everything according to the book. They were told to diversify, so they diversified. Why didn’t it work?
Why did diversification fail so many retirees and imminent retirees? Because they were diversifying the wrong thing. The ultra-wealthy don’t focus on diversifying stocks; they focus on diversifying INCOME. They invest in a way that will ensure they will continue paying their bills even if they cannot work.
There are two levels of income diversification – one, diversification through creating multiple income streams, and two, diversification among the income streams to protect cash flow. The first type of income diversification involves creating additional income streams beyond your work income. There are not enough hours in the day to take on additional jobs, so smart investors get around this by investing in private investments that generate passive income.
Your body may not be able to work multiple jobs all day, but your money can. Investing in multiple cash-flowing assets makes it possible to walk away from your job if you choose or are forced to. Only through creating and protecting multiple streams of passive income can you avoid the fate of many unprepared Baby Boomers.
We talked about the first type of income diversification – income creation beyond income from your day job. This cuts reliance on the time clock. The second type of income diversification is income protection. Once you’ve created additional income streams, it’s important to protect that income. Investing in multiple assets across different segments and geographic locations protects cash flow – even during a downturn.
Allocated to the right assets, even if one or two assets in your portfolio suffer a setback, the other assets will pick up the slack and see you through the hard times.
Income protection allows the ultra-wealthy to continue to build wealth through any economy – good or bad. By depending solely on the appreciation of a diversified portfolio, the average investor deprives themselves of passive investments that generate cash flow that can be reinvested and compounded to grow and maintain wealth.
A diversified Wall Street portfolio won’t protect an investor in a downturn. A portfolio of private assets – uncorrelated to Wall Street – with a diversified income stream helps savvy investors weather storms and ensures continued cash flow for building wealth without interruption.
When Wall Street touts diversification, ignore it. The one thing you’re not diversifying that you should be – like the ultra-wealthy are doing – is income. Diversification through creating extra streams of income and protecting those streams will not only prepare you for retirement but will make it possible to retire early and live your best life now.
