Whenever I hear someone get really excited about their latest investment, I tend to think the worst. It’s not that I don’t want that person to succeed but I usually worry they’re making a big mistake. Any time I see a friend buy a house, I wonder if they spent more than they can afford. Any time I see a friend buy a new car, I hope for their sake that they paid cash and aren’t going to have an egregious car payment every month on a rapidly depreciating asset.
I can’t help but feel sorry for a lot of these people since most of them are going to have to learn the hard way about living within their means. And there’s really nothing you and I can say or do that will change their mind since it takes a real financial epiphany(like losing your job and realizing that you’ve been living paycheck to paycheck on a 100k annual salary) before they’ll make any real changes. So most of the time I just keep my mouth shut and worry about my own plan.
Since I run a personal finance blog, a lot of people assume that I must invest in some pretty game-changing stuff. But the truth is, my investment style is actually pretty boring. I try to maximize returns while taking on the least amount of risk all while keeping things as simple as possible. I know that the stock market is very efficient, thus any time something sounds too good to be true, it probably is. If you’re getting above average returns, it’s probably because you’re taking on above average risk, simple as that.
One of the things I’m always worrying about these days though is my diversification strategy. Most people know that it’s important to diversify their investments between stocks and bonds but what about the other areas of your finances. I think diversification plays a huge role in every aspect of our financial life yet most people overlook it. Here are all the ways I’m currently trying to diversify my financial life:
Stocks & Bonds
Like I mentioned, this is the most obvious area to diversify in since it just doesn’t make mathematical sense to invest in a single stock(that’s called uncompensated risk). Professional money managers that get paid millions of dollars a year can’t consistently pick winning stocks so why should I waste my time even thinking I can? Since I’m so young, I hold about 90% of my retirement accounts(401(k), Roth IRA and HSA) in stocks and the other 10% in bonds(as Dave Chapelle would say, “don’t forget to diversify yo bonds“).
My stocks are broken up into 60% US Stocks and 40% International Stocks. It’s important to diversify with international stocks since your entire active income usually depends on the fortune of the US economy. A lot of people fail to consider that their job security and salary depend heavily on the fortunes of the US economy. Adding in some international stocks is a nice hedge in case things go south here in the US. You don’t want to lose your job and your portfolio at the same time.
Within my domestic stocks, I also diversify 10% into small cap companies and within my international stocks I diversify 10% into emerging markets. It’s a pretty common strategy to tilt towards emerging/growing markets since those stocks tend to have higher returns(but more volatility).
When I quit my last job to move up to Orange County with my fiancee, everyone I talked to thought I was crazy. They told me there was no way they’d ever be able to take that kind of risk. All along though I was thinking to myself, what’s the risk? I might not find another high paying job but so what, I was prepared for that scenario. At the time, I had four additional streams of income coming in: coaching income, blogging income, freelance writing income, and rental property income. Obviously those additional sources of income didn’t equal my day job salary but they didn’t require 40 hours a week of work either. And the nice thing about all those secondary sources of income was that I would be able to continue doing them no matter where we moved to.
One of my pet peeves is that I hate depending on other people for anything in life. It’s easy to get comfortable doing the same routine day in and day out taking home a nice paycheck from your day job. But you have to remember that there’s no loyalty in the corporate world. You can be fired at any time for almost any reason and you’re always at the mercy of your employer. Even though my day job income makes up a majority of my income, I will never depend on it.
Real estate is an area where people tend to either over diversify or under diversify. This is one of the battles I’m struggling with right now since I think real estate is a great investment but I don’t want it to make up more than 35-45% of my net worth. Housing prices are already starting to creep up to pre-housing bubble levels and it seems like buying a house in Southern California at least is mission impossible. I can’t even afford to buy a house in areas that I don’t want to live up here in Orange County.
Real estate over diversification is an easy trap to fall into since banks generally loan out more money than most should ever accept. But not many homebuyers are going to turn down free money(see subprime mortgage crisis). Housing is also a very illiquid investment since once you put money in, it’s a lot harder to get it out. There’s a lot of pressure though to be a homeowner and I think this forces people to buy houses that make up way too much of their net worth. It’s tough to fight the herd and go at your own pace when all your friends are buying nice houses, but that’s what you have to do if you want to be a smart investor.
I don’t think alternative investments are a necessary portion of a successful portfolio but they can serve an important purpose. With investments like Lending Club or start-up type funding, there are huge rewards for taking on additional risk. I’m getting a 12% return in my Lending Club Roth IRA right now and it feels great. I’m outperforming the stock market and even though it’s only a very small portion of my portfolio it satisfies my hunger to actively trade.
Alternative investments also keep you grounded though. If you decide to do a little active trading with 1% of your portfolio and you lose it all, that was a very cheap but valuable lesson. I try to limit my alternative investments to 5-10% of my portfolio. Currently, my Lending Club Roth IRA is my only real alternative investment at around 4% of my portfolio since I recently sold all my American Airlines shares.
Taxes are the last part of my diversification strategy. A lot of people overlook tax diversification because they’re so focused on the other stuff. But diversifying from a tax perspective is just as important as your stocks and bonds diversification strategy. The common pre-tax vs after-tax argument is that your income in retirement will be lower than your current income so you should contribute more to pre-tax accounts like a 401(k) and traditional IRA now. But if things go the way I want them to, my income will actually be higher in retirement than it is right now.
The second thing you have to consider is the future of tax rates. I have no idea where they’re headed and neither does anyone else. You might think taxes are high right now, but did you know the highest marginal tax bracket in the 1940′s was over 90%? The truth is, we might have an idea of where our income will be in retirement but we have no idea where taxes will be. I like to contribute at about a 3:1 ratio of pre-tax(401(k) & HSA) to after-tax(Roth) in order to achieve adequate tax diversification.
I wouldn’t want to enter retirement with a $5 million portfolio and have to pay taxes on all of that money due to some new liberal president. Conversely, I also don’t want to pre-pay too much in taxes right now since rates could go lower, my income could go lower or the government could impose a total asset based tax that would affect Roth IRA’s.
Readers, what do you think about my strategy to diversify everything? Did anything stand out or is there any one area that you would diversify more/less?
-Harry @ PF Pro
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