The Limits of Diversification

When I was very young, one of my co-workers (who had already tagged me as a finance nerd) asked me for advice on investing his 401K. This guy was contributing ~5% of his meager salary into a wee little account, but he was still really worried about his investment options. He wanted to choose good ones and ensure he was – of course – fully diversified.

I told this guy, who was over-enjoying being young in the big city, “You want some real investment advice? How ‘bout you stop getting hammered on Thursday nights and coming into work Friday hungover?” (I tend to give the advice you need, rather than the advice you want…)

This guy’s career and future earnings were thousands of times more valuable than his chumpchange 401K, and he was completely ignoring the damage being done to this precious, hard-to-diversify asset. His work performance and reputation were suffering, but he was just worried about achieving some nirvana of equity diversification in his retirement account.

 

Diversification is really important in equity investing and is oft cited when heralding the advantages of low-cost broad-based index funds. It goes far beyond that, though. “Don’t keep all your eggs in one basket” is accepted general wisdom the world over.

The key to diversification is correlation, or how much things tend to move together. If you bought 30 different stocks, but they were all retailers, you wouldn’t be very diversified – the returns of one retailer would likely be highly correlated with the others. If you bought 30 stocks from totally different industries, their returns would be much less correlated and give you a more diversified portfolio.

However, diversification has its limits, particularly within specific areas of your life. Not only may it be hard to try to diversify some assets, it may be unwise.

CAREER / TRADE

At the beginning of our careers, our future earnings represent one of the biggest assets we’ll ever have. The trouble is that this asset is highly undiversified – it is specific to your ability to work and your particular skills.

Making things worse, we are heartily encouraged by the market to further concentrate our exposure. A highly specialized skillset is often richly rewarded, while a much more diversified “jack of all trades” may earn much less. Unless and until the market turns against your chosen profession, you are often encouraged to become an ever-greater expert in a ever-narrower field. It’s incredibly lucrative, until suddenly it isn’t.

How should you attempt to diversify your career asset?

  • Resist extreme pigeonholing
    While you may be richly rewarded for an extreme specialization, you don’t have to accept it. Develop the skills and brand yourself as more than a one-trick pony.
  • Build transferable skills
    While some skills are at risk if the market turns, others, like management ability and communication skills, act like levers and help almost any career path. Combining a unique specialty with more general capabilities can sharply lower your risk.
  • Diversify across time
    Make hay while the sun shines in your current specialty, but retain the hard work ethic and ability to learn that will allow you to pivot if needed. If you’re lucky you’ll make a mint and need no second act, but a second act doesn’t have to be a disaster scenario.
  • Consider disability insurance
    The more specialized and less transferable your skill, the more you’ll need. There’s a reason athletes and entertainers insure their relevant body parts for prodigious sums.

And finally, the best way to address an undiversified career asset is simply to save money. Turning your human capital into a massive pile of financial capital gives you much better options to diversify. If your chosen field goes away, but you’re already on the cusp of retirement, what do you care?

HOUSE

A house is one of the biggest purchases most folks make. (We’re talking residences here – rental real estate is a different and better animal.)

Some people have made killings and funded their retirement through selling their primary residence 30 years later. I used to hear regularly, “Buy as much house as you can afford.”

A house is a dangerously undiversified asset, though. There isn’t much you can do to diversify it (and no, buying a second vacation home is a terrible idea).

The best way to address this is simply to spend as little on your house as possible. The faster your house becomes a small part of your overall net worth, the better.

You also need to remember our friend correlation. Let’s say you work in an industry that dominates your local economy. If that industry fails (along with your career prospects), it may kill the local housing market and crush your house’s value. That type of career + house whipsaw makes an undiversified stock portfolio look like child’s play.

SPOUSE / SIGNIFICANT OTHER

Now things are going to get interesting.

Your choice of a spouse (both if you’ll have one and, if so, him/her) is one of the biggest financial decisions of your life (we’ll ignore the romantic / cuddly aspects for today). From a financial perspective, this asset (or, in some cases, liability) can dwarf all others.

And yet, for this most important of assets, I recommend a completely undiversified approach. I think the ideal number of spouses / significant others is one. Putting all of your eggs in one basket indeed!

How can you address being dangerously undiversified in one of the biggest assets of your life?

  • Do your diligence!

If I told you your entire financial net worth needed to be invested in a single stock for the rest of your life, you would sweat bullets and do more diligence than you’ve ever done. It would be a monumental, life-changing decision. Contrast that with the blissful nonchalance with which many people enter marriage.

Choosing a spouse is probably the most important decision of anyone’s life. The amount of thought and care used to make the decision should reflect that. Do your research and choose wisely!

  • Try to find a spouse with a low correlation to your other assets

Bear with me – this is actually a very romantic sentence in deep (deep, deep) disguise.

It’s surprisingly easy to find someone who will stick with you if you make a boatload of money and are super rich. However, what if that person leaves at the first sign of trouble (and, as a bonus, takes half of your stuff with him/her)? That type of spouse is highly correlated with your career and investments – when things are great, they stick around and make you happy; when things turn bad, they’re gone.

The key is to find a spouse who will stick around for the “…or for worse” part. If your career falters or your investments fail, and your spouse is still there standing by you, that’s an awesome thing. Your spouse might be undiversified, but he/she is also uncorrelated with your other assets, and that’s true love. See, I told you it’d be romantic.

An added bonus is if your spouse works, especially (remembering our goal of diversifying) in a very different function and industry than you.

Final Thoughts

Always keep in mind that our financial investments are just one aspect of our total net worth.
Religiously diversifying a stock portfolio while blindly ignoring the concentrated risks we have in our careers, our houses, and our spouses is foolhardy (and bad portfolio theory, to boot).

Some things are hard to diversify, but that just means they require a more thoughtful and strategic approach. Take a holistic view to everything you have and own, and you’ll have the best possible portfolio – broadly defined 🙂

 

 

2 thoughts on “The Limits of Diversification

  1. Neat take on diversification!

    I appreciated what you wrote about spouses and houses 😉
    I’ve had a family member who owns a house and a condo near to each other with mortgages on both tell me about how he is nervous about buying stocks because of the risk.
    I have a fairly aggressive portfolio but I’m convinced that risk associated with my investments is still lower then his, since I’m spread across multiple regions/industries while his “investment” is tied to not only the economy of one country, but one province and even a single city.

    I’m ignoring the whole “You have to live somewhere” argument for now.

    The spouse thing always surprises me too, I see people getting married who have very different approaches to finances quite often. It will at the very minimum add a lot of stress to a relationship, but has the potential to destroy lives.

    Thanks for the article!

    • Many thanks Matthew!

      I agree with you – a levered house + condo combination in the same city seems incredibly risky, but those situations somehow get a free pass. The argument for diversified stock investments have benefited from academic studies, constant attention, and the efforts of greats like Mr. Bogle, but I wish folks would apply the same underlying logic more widely in their lives.

      And yes, the marriage thing is a head scratcher. People are remarkably cavalier there while religiously measuring and managing risk in smaller matters. At least, when they split up marital assets, the portfolio will be well-diversified 🙂

      Thanks again

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