I’m a big believer in diversification. Putting all your eggs in one basket is dangerous, especially in your personal finance. Diversification is a good way to reduce your risks. The question is how we should go about diversification.
Recently, through a lecture by Professor Robert Shiller, I got a deeper understanding of diversification.
In the lecture, Professor Shiller explained that risk – in mathematical terms – is represented by variance, which is a measure of how fluctuating something is. Potential return, on the other hand, is represented by average. An investment could have a high average (that is, high potential return), but if it also has a high variance (that is, highly fluctuating) then it’s risky. Yes, you might get a high return, but there is also a chance that you would lose big. The ideal, of course, is to have a high average and a low variance.
Now I’d like to focus on the risk side of things. To minimize risk, what you need to do is minimizing variance. And the way to do that is by diversifying your portfolio. But there is one important condition: the components must be independent of each other. That is, the fluctuation of one investment must not have any effect on the other investments in your portfolio. If you can meet this criterion, then you just need to keep adding new investments to your portfolio and you’ll reduce your risks over time.
Applied to personal income, it means that you should diversify your income streams in such a way that they become independent of each other. If you don’t do that, then you don’t actually reduce your risks.
Based on this understanding, there are four levels of income diversification (from the worst to the best):
1. You have only one income stream
This is the worst situation to be in. When something bad happened to this sole income stream, the effect will be devastating. An example of this is salaried employees with no other income stream. If they lost their jobs, their entire income would disappear.
2. You have more than one income streams, but one of them dominates
This is better than level 1, but the effect will still be bad if something happened to the main income stream. The majority of the income will be gone, but the good news is that some of it will remain intact.
3. You have relatively balanced income streams, but some of them are dependent on each other
Here you have several income streams and none of them dominates. This is good, except for one thing: since some of them are dependent on each other, they could all go down at the same time.
4. You have relatively balanced income streams, with no dependency between them
This is the best situation to be in. Here, when something bad happened, you will be able to keep going and suffer only minor damage.
Here is a good question to ask yourself to guide you in your diversification effort: What is the worst single point of failure that would be devastating to your income?
For some people, it’s losing their job. For a business owner, it might be losing a big customer.
What is it for you?
After you have the answer, you should work on minimizing its impact. Your goal is to diversify your income streams in such a way that there is no single point of failure that could devastate your income.
It might take years before you reach that point (I’m still working on it myself), but I believe it’s an important journey to take. And since it might take years, you’d better start soon.
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