Why diversification is super important for financial independence

Why do you need diversification in a financial independence campaign if stocks average 9% a year? Here’s the argument for diversification and why I believe it’s super important for financial independence.

This is not financial advice – it’s for discussion and entertainment purposes only. If you are inspired to do research off the back of it, great!

What’s diversification, anyway?

Don’t put all your eggs in one basket

Traditional proverb

When you buy a share, a bond, a single cryptocurrency token, or whatever – you’re at risk. Lots of risk. Even if your plan is to stockpile cash in your mattress until you sleep on it like a dragon, you’re taking a few risks.

For starters: there’s opportunity risk. That’s the risk that you choose to do one thing but miss out on something else by doing it. In investment terms, this means that you would invest in a poorly performing asset and miss out on other, better performing ones. If we use the egg basket, this would be like only buying chicken eggs but missing out on quail eggs or duck eggs or whatever.

Another is concentration risk. This is sounds really simple but it can grow legs and get complicated really quickly. Using the egg basket from the proverb, this is the risk that you drop the basket and break most/ all of the eggs.

There’s one more risk that I think you should know about: inflation risk. This is he risk that your assets drop in value because more and more of them are created. It’s also the risk that a debt security (like a bond or interest rate on savings) doesn’t pay enough for your cash to keep up with inflation. It’s usually the case for cash (yup, cash should be considered like an investment), but it’s technically true for things like share splits and so on. Inflation risk is like buying a load of eggs for your basket right before the shop puts them on buy-one-get-one-free or drops the price.

Diversification then is making sure that a) you have a mix of eggs and b) you have several baskets. It’s about risk reduction from concentration risk and trying to make sure that you seize opportunities to minimise opportunity risk.

We’ll come back to the inflation risk thing later, I promise.

The classic case for diversifying your assets

Believe it or not, ETFs aren’t actually that old. They’re allegedly a 1990s thing. Investment trusts are a little older, dating back to the 19th century, but they’re largely a UK thing. This is important to know because a lot of the classical models for portfolios are written based on studies from the USA or predate ETFs. This means that when they talk about diversification, they’re restricted by what was commonly available at the time.

The Intelligent Investor on diversification

Benjamin Graham’s book The Intelligent Investor talks about splitting equities (shares) and bonds. He suggested a 50-50 split, unless bonds or shares were particularly attractive purchases that year, in which case he suggested to never be unbalanced more than 75:25 in either direction.

There are many good bits of the book. For starters, the way that Graham describes value investing. However, Graham talks about getting the market average performance by having a selection of shares in different companies that meet the value criteria. This is because the last update that he made to the book was in the 1970s and single share purchasing was still the primary way to buy shares for your average investor.

There were of course collective investment schemes such as mutual funds available to Graham. These offer diversification to an investor, but it’s a bit like giving your basket to someone else then asking them to buy whatever eggs they want to. You also have to pay the fund manager in fees. Graham was quite critical of them for the “DIY investor” and they don’t get great treatment in the book, apart from to say that the top performing funds in one year tend to be the worst performing the next and overall rarely beat the market average performance.

Bill Bengen’s 60-40 portfolio

I don’t think this was actually Bengen’s idea, but Bengen was the creator of the 4% rule. The 4% rule has since been played down by Bengen himself, but it’s still the rule that most financial independence plans are based on.

Importantly, Bengen based this on a portfolio that used 60% shares to 40% bonds as its diversification. That’s right: just shares and bonds. I’m going to confess that I don’t know whether that meant shares bought individually or whether funds were included, but it’s still just two types of asset.

I’m quite critical of bonds in 2021. I don’t think that they’re good value. However, there are other assets out there (such as real estate, gold, maybe crypto, rental income from other stuff etc.) that Bengen’s portfolio just didn’t consider. This is probably because shares and bond funds are so liquid and easy to buy in small quantities for your average everyday retail investor. Bengen’s model is based on a regular retiree, after all.

What the old models say about diversification

It’s clear that the older models do have some diversification built in. The 60:40 portfolio and an Intelligent Investor approach consider having a split of equities and bonds, so there are at least two types of asset in their suggested portfolios. Whether you use a fund or buy individual shares is another matter. Graham suggested picking a few companies in each industry, so that you would end up with at least a dozen and can expect average returns without too many fees. I wonder if ETFs would have changed his perspective.

What’s good is that shares and bonds have historically been priced against each other. When prospects are good and business is booming, shares increase in price as investors rush into the stock market. When times are hard, investors rush to bonds to weather the storm. This is because bonds produce a fixed rate of interest and are safer than shares (especially gilts or treasury bonds), but rising shares tend to offer better profits in good markets than bonds will.

All well and good, you might think; buy some bonds and some ETFs and I’ve got myself some diversification! However, there’s a few problems with these basic models in the present day.

Why you might be tempted not to…

When you speak to a stockbroker about diversification, they’ll tell you about a mix of shares and bonds – and that’s generally about it.

Yes, that’s right – if you’re a more cautious investor, you’ll be sold more bonds and gilts. If you’re more adventurous, you’ll be sold some ETFs that buy shares and maybe 20% will be put in bonds. If you’re absolutely terrified of investing, you’ll keep a lot of cash.

This sends out the message that confident people buy more equities. Confident investors like you should buy shares! So, if you’re confident in the performance of the market, why not buy only equity ETFs? After all, the historical market performance of the global stock markets is about 9%! If I have a bad year, surely I can just wait a bit longer until markets recover?

Sure, you can. Good luck to you. With a modern ETF or a decent investment trust, you can expect to buy into a diversified pot of at least 50 shares. A global all-cap world tracker like this one contains shares from 6,819 different companies. You want diversification? This is a pretty good start!

Except that you’re concentrated in one asset type: shares. Welcome back, concentration risk! Equity markets can on occasion fall collectively as investors panic about macroeconomic and systemic events. Good examples would be the March 2020 response to coronavirus, the 2008 collapse of Lehman Bros, the dotcom bubble burst… there have been quite a few. I dimly remember all of these being “once in a lifetime” events, so I guess we’re just lucky. There’s a really great article by investopedia that explains the history of stock market crashes – try not to let it freak you out, though.

…and why you should diversify anyway!

This isn’t a problem in the long term while you grow your pot. Well, not really. While you’re growing a fat stack for financial independence, crashes mean cheap buy-ins on ETFs. Hooray! You have to love a great buying opportunity.

But – and it’s a big but – you’re going to want to retire early on this stack, or at least hit financial independence. What happens if this drops when you’re drawing down? Well, you’re going to have to sell off some shares that you paid full price for at a discount. That sucks!

If you’ve been smart though, you’ll be diversified. That means you’ll have something else that’s on a roll to sell when everything else is temporarily crashing. That way, you’ll be selling fewer things overall to keep yourself afloat, giving your shares time to rebound back to reasonable prices. Once things start to stabilise, you can then rebalance your portfolio to make sure you’re properly diversified again.

I’m not going into rebalancing in this post. It’s long enough and this is quite a lot of typing. However, there’s a really good video below from Pensioncraft that explains why rebalancing a diversified portfolio tends to lead to good gains overall. The basics apply to drawing down, too, but obviously that’s about minimising what you have to sell rather than maximising growth.

The problems and pitfalls with diversification in 2021

Here’s the thing, though: bond yields suck. Really suck. Remember what I said about inflation risk earlier? Well, bonds are a debt security, which means that they pay in cash. That means that if the yield from them is a lower rate than inflation, they’re an asset that is devaluing over time.

That’s quite a technical point. If you’re not sure what I’m talking about, check out my explanatory post on bonds first.

Now, that’s a problem in 2021. Yields are definitely lower than Consumer Price Index inflation, i.e. the UK’s target rate of inflation. Bonds you buy are therefore better than putting cash under the mattress, but they’re not making you any wealthier or preserving the value of the money you put in. So, what can we do now? Are we all doomed to buying only equities?!

Well, no. Fortunately there are other options for diversification that you might consider for financial independence.

“Asset Classes” and what to look for

Buying into funds or having a whole bunch of different shares is one way to diversify. That’s basically diversification within a class of things. You should definitely do it, it’s a good idea. However, if you want to prevent market risk, you need to diversify across markets. Ideally, completely unrelated markets. To give yourself the best chance, you may want to consider buying different types of things. Different asset classes, as it were.

“The X types of assets are…”

As I discovered when I started investing, there’s a usual way that these kinds of posts are written. I think I’m supposed to say something like “the three/ five/ 227 asset classes are…”. In fact, if you Google search, you’ll get recommendations like this one:

Truth be told, I don’t believe that there’s much value in “asset classes”. I liked the simplistic, Robert Kiyosaki explanation of “asset”: something that makes you wealthier. If I’d known Pokemon cards would sell for millions I’d have encouraged 12-year-old me to stash some away for my future! In the right hands at the right time, lots of things can be worthwhile investible assets.

That said, some of the more common asset types look a bit like this list below. All of them have upsides and downsides to ownership.

Cash

Maybe cash is king. Maybe cash is trash. Maybe it’s something in the middle, or a bit of both. Cash is great because it’s usually the only thing you can spend in the shops. Unfortunately, it’s also inflationary. The only way you can build up a financial independence pot with it is through savings, and savings accounts aren’t great in 2021. I get 0.4% interest on mine, and that’s a good rate. It’s not really volatile but the inflation risk is obviously quite high if savings interest is lower than inflation.

Shares

The classic. I’ve written enough about shares, read this post if you’re interested. As an asset, shares fluctuate in cash value. They are usually inflationary, a company can create more of them, but they tend to either grow in value or pay cash dividends at a much faster rate than they can be created.

Bonds

I think we’ve covered bonds. They pay cash interest but it’s not great for retail investors, who are usually buying them at a premium.

Gold

Shiny metal, historically grows in value faster than cash inflation. Gold isn’t really inflationary as it’s hard to mine and demand is huge. It’s quite a lot of effort to create more of it. That said, it also doesn’t produce anything, and if the world stops believing in it then it’ll become just another rare shiny metal.

Real estate / property

Land has value. I mean, it has cash value, but it also has value of itself. You can get shelter from a house, you can farm fields, you can get firewood from forests, water and fish from rivers… yeah, yeah. In the UK we love buying houses for that reason. The good thing about real estate is that it’s rare and usually in high demand, so it tends to increase in value while producing rent or providing a resource. The bad thing about it is that it always needs maintenance, it’s never really passive unless you pay someone else to do the work (which is one of the reasons I like REITs).

Intellectual property

IP includes things like licences to use something, patents, copyright over content and so on. Original ideas can often be used to make money so they’re definitely assets. The problem is that they’re often quite difficult to make money from without luck/ connections/ a leap of blind faith.

Fine wines / spirits / art/ other collectibles

I’m being lazy here and clumping a lot of things together. Some stuff just gets rarer and more widely appreciated after its time. Fine wines and spirits generally get rarer over time, so some of them can be quite valuable (don’t ask me how to pick them, though – I’m firmly on the side of being a consumer!). Some artwork isn’t appreciated until long after the artist has passed away. If you know your audience and can buy things at a cheap price, in the right hands anything can be an asset.

Cryptocurrency?

Highly volatile, potential to become obsolete in the future, crypto is potentially an asset or potentially just a huge liability. I’ve talked about cryptocurrency interest earnings on stablecoins before but let’s be honest: most people buy crypto and hope that they’ve backed the right horse that will grow in value on its own accord. Use at your own peril/ risk.

Cool story, but how do asset classes help me diversify?

This has been a marathon read, so I should probably reward you for your patience!

You can probably work out that more asset classes will mean diversification. That’s not hard, I could have told you that in one sentence. However, unless you have limitless wealth, you can probably only buy a couple of things at a time. This means that you need to plan which asset classes you’re going to buy. This is harder than it looks.

The aim is to buy into assets that have as little correlation as possible. That means that when one increases in value, the other decreases. If you can’t manage that (or, as with bonds and I, don’t want to) then the next best thing is to invest into assets that don’t correlate much. That way the price action is at least independent.

I’m about to scare you with some of the worst diagrams ever. These are called correlation matrices (singular is “matrix”) and they show how different assets have performed in relation to each other, historically. If the score is “1” (or “100%” if percentages are used), the assets are perfectly correlated. They both increase in price at the same time. If they’re -1 (or -100%) then they’re perfectly inversely correlated, i.e. prices move in opposite directions and they’re perfect for portfolios. If they’re at or close to zero, there’s no connection at all.

The table below is from Vanguard (as it’s popular with the financial independence crowd). If you like that one but want a fuller, more diversified experience, here’s the 2021 matrix from JP Morgan.

From Vanguard Investor

You can see from the matrix that shares and bonds are generally (slightly) negatively correlated. That explains why they’re the classic building blocks. However, you can also see that REITs are a lot less correlated to equities than equities from other countries. They’re at least doing something for diversification.

If you took the plunge and looked at the JP Morgan monster sheet, you’ll see that gold is pretty much doing its own thing compared to most assets. Interestingly, gold and real estate seem to be somewhat negatively correlated, which means that you could do a lot worse for diversification than buy lots of real estate and start stacking gold coins, like a prepper. I wonder if they do that by chance or by design?

How I use diversification in my own campaign

I’m quite vocal about being against bonds. I have a token splattering of them in my pension, because over time they might improve, but I don’t have any in the ISA.

Correlation (or lack thereof) does steer my investments somewhat. I’m mainly in equities, because they show consistent gains over time. However, I also hold REITs and gold in my portfolio to counterbalance. My partner and I also overpay on a mortgage, which is quite a heavy real estate investment. We hold an emergency fund but because we are quite well diversified, live quite cheaply and are reasonably confident in our employment prospects we feel that we can keep the cash as low as 3 months’ expenses. This is a good thing, too, because cash savings aren’t doing well for anyone. There’s a risk in that if we are both unemployed during a recession that we will eat into our financial independence progress but we’re diversified enough that we can probably minimise the losses to the portfolio.

Hopefully that’s some food for thought!