#16 - Risk Diversification (finance)
Updated: Apr 24
Risk was recently discussed but an important aspect of this wasn’t - Risk Diversification.
Risk Diversification - the balancing our Risk Tolerance with Risk Capacity. I was blessed to have a conversation with some very smart, well spoken people within the firearm training industry recently, and realized risk is essentially what ties Finance and Personal Protection together. We don’t want to die or be monetarily broke, but we also want to experience life today and in the future. What’s the happy medium?
How do we diversify our risk? The easiest ways are:
1. The longer we hold something (especially if we keep contributing), daily, monthly, and annual variances matter less. Short term volatility is just a blip on the radar if our time horizon is long enough. Colloquially, once we realize this truism, our stress levels tend to drop as media sensations become white noise. This isn't timing - we must stay the course to reap the rewards. Don’t sell because markets are going down, or buy because markets are going up.
2. Investing in locations besides our home town/country, spreads risk to different economies. Just because the USA may be having an economically tough time, doesn’t mean that ALL financial markets are having a tough time. Professor Scott Cedersburg's research of all recorded financial history in all countries, demonstrates international diversification reducing failure chances from 14% to 3% over 20 year periods. This may seem small, but the gap between those odds is 78%!
3. Asset correlation simply means some things zig while others zag. Broadly speaking, examples include cash, bills, bonds, and equities. By diversifying across these asset classes we further spread our risk. Academics looking to optimize market models over time have shown different categories (factors) have different correlations - to broad markets and to each other. Factors are defined as persistent drivers of excess returns, which are present across time and global markets. A warning here - targeting specific factors can deviate from common benchmarks significantly during the short terms; holding broad asset classes may be less stressful for many.
4. Location refers to what accounts we are putting our money in - long term results can be boosted significantly if accounts are tax advantaged. For short term, I’d stick with cash set aside for goals and emergency funds. While inflation will impact these accounts, the balance won’t fluctuate (savings accounts, CD's, etc.). For medium term (5-10 year) goals, investing in a taxable brokerage account may be beneficial compared to cash; the caveat is to hold assets over a year. By doing this, profits become long term capital gains, which are taxed at half your income rate (so the tax man helps you out - double win). For long term goals (multi-decade), tax advantaged accounts tend to be king; tax deferred accounts give current year tax breaks, while Roth accounts give tax-free future growth. The trade off for tax benefits is a strong reduction in liquidity (waiting for retirement).
In summary - let’s not put all of our eggs in one basket. Let’s put them in some over here, over there, some that add more eggs, and some that occasionally give more chickens (which make more eggs).