Blog | Personal Finance

The Good and the Ugly with Diversification

Diversification is a dividing word. Yes. Pun intended

Almost every financial planner will tell you to diversify your stock investments. And of course, if they were worth listening to, they would have trained for more than two weeks. Yes. Sarcasm intended.

Here is another point of view,

Mark Cuban once said, “Diversification is for Idiots”.

And,

Warren Buffet said, “Diversification makes very little sense for anyone that knows what they're doing.”

Rich Dad has a little bit different view.

We do not believe in diversifying stocks or anything in an asset class. Generally, when one stock goes up, they all do. And when one goes down, they all do. Generally.

But asset classes do not work that way. Often when one asset class goes down investors jump out of those investments and go looking for a safe place to put their money. So if the Real Estate market crashes, an investor may place their money in the stock market, or crypto or gold. It depends what asset class is doing the best.

When we diversify at Rich Dad, we mean that it is good to invest in multiple different asset classes. We do not say that just to protect your investments from wild swings but also because each asset class has its own set of pros and cons.

For example, Real estate is easy to cash flow, has great tax advantages and lets you use debt to build wealth. But… if you need to get your money fast, real estate is not liquid. It often takes months to sell a property.

Stocks, on the other hand, are incredibly liquid. You can get money out in seconds. It does not take much money to get started and can make money in any market. But… there aren’t many tax advantages, you can’t use debt as well as you can in real estate and cash flowing is a bit more complicated (though incredible once you learn how).

With this in mind, we’ve asked Sally Outlaw from Worthy.us to introduce some very unique ways to diversify and build wealth while helping others. While we do not give investment advice, we do think Sally has something to say worth (pun unintended) listening to.

Private Market Bonds Can Be a Way to Diversify Your Investment Portfolio

Sally Outlaw – Founder and CEO of Worthy

Smart investors know that diversifying their investments reduces risk. You want to diversify your portfolio in terms of asset classes, investment vehicles, industries, risk profile, and other classifications. Diversification maximizes financial returns by investing in different categories of securities that each react differently to the same event.

It doesn't bulletproof your portfolio, but diversification is a critical way to reach long-range financial goals while minimizing risk.

Investing in equities, whether directly in an individual stock or through mutual funds, or exchange-traded funds (ETFs) that track equity indexes, may deliver a greater return on your investment than bonds. Still, equities also have a higher risk of not providing a good or consistent return.

When significant events happen—such as the coronavirus or political unrest—the stock market gyrates. If your portfolio has only public stocks, you could experience a big drop in value. If you counterbalance your investment in stocks with investments in bonds, only part of your portfolio would be affected as typically, the stock and bond markets move in opposite directions. Suppose your portfolio is diversified across both asset classes. In that case, a downturn in one will be offset by an upturn in the other. In general, many bonds are considered to be lower risk than stocks, though neither asset is risk-free.

Investments in stocks and bonds may also come with fund management fees, transaction fees, or brokerage charges. Costs for buying, selling and even for holding them can add up and need to be accounted for when considering your overall return on investment.

Given market volatility, it's important to consider more than just publicly listed stocks and bonds when diversifying your portfolio. By and large, it is easier to invest in public companies than private ones. Public company stocks are traded on the stock exchanges and are easily accessible through brokerage accounts with a variety of providers. Until recently, equity investments in a private company used to be only open to the wealthy. It also required a minimum investment of tens of thousands of dollars and the opportunities were harder to find. Investing in private credit, that is, giving loans to private companies, used to be the same – wealthy individuals loaned large amounts to private companies, which were most likely mid-sized companies.

The investing landscape changed however when the JOBS Act was created after the 2007-2008 financial crisis.

It allows any American, 18 years or older, to invest in both the equity and credit of private companies. In a nutshell, private credit generates financial returns from interest earned on the loans they provide. Private equity makes money as the value of the company increases, so the value of the stake or shares one holds in the company also rises. In private equity, you make your money when the company goes public or is bought by another as this gives you an “exit” – meaning a way to sell your shares in the company. Private credit companies typically employ teams with strong commercial banking backgrounds and expertise in the debt instrument they are offering. These teams assess the ability of companies to repay the loans. Though the reward may be more significant, private equity is usually a riskier investment than private credit as the investment is not secured like a loan may be.

The use of private credit was growing among mid-sized companies before the Great Recession, but now fintechs—financial technology companies—are making these types of loans more readily available to growing businesses including real estate developers. These loans are usually more flexible and responsive to the challenges small businesses face than traditional banks are. The business gets needed financing and small investors get a good return.

Investing in private credit among institutions and the wealthy was also growing before the financial crisis. Now you can invest too. Companies like Worthy make it easy to invest in growing community businesses and real estate projects by assessing the risk for you and by bundling investments to spread the risk. Instead of needing to invest tens of thousands of dollars, many of these new fintechs also offer micro-investing with as little as $10.

By diversifying into private credit or equity, you're not only helping to move the economy forward, but you’re protecting yourself from the ups and downs of the public markets.