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Articles » Finance » Investing >> View Article

Diversification is Key to Investing Successfully

By: Clinton Swaine

“Do not put all your eggs in one basket” ~ Unknown

This is an interesting law. At one point there was an alternate theory “Put all your eggs in one basket and watch that basket very carefully.” This theory has merit on the condition that you have direct control of the basket and can affect its outcome upon demand.

A key to the ability to manage the basket is whether the basket has any liquidity. Liquidity is the ability to turn the asset into cash at short notice. As cash is effectively a movable asset immediately, it is the base measurement. In a stable stock market, stocks are considered highly liquid in that within days most stocks can be sold and turned into cash. CDs, bonds and other financial instruments may be liquidated with penalties. Residential real estate in the median price range is moderately liquid. The higher above the median price you go, the greater the difficulty in turning it into cash. Similarly, commercial property is much harder because there are far fewer buyers.

A custom commercial piece of real estate may be on the market for years. Stocks in a private company have almost no liquidity if the other members do not wish to buy them. The majority of small businesses are also incredibly illiquid, and a death of the principal will often result in the business closing down, or having a fire sale for a P/E ratio of ½-2. This means that the business is sold for ½ a year to 2 years profit plus a negligible amount for inventory. As an investor you have to be present to the liquidity state of your portfolio.

Registered Investment Advisors have guidelines about how large portfolios should be managed according to the age and risk profile of the owners. Portfolio Theory talks about asset classes and makes sure that only a small amount of money goes into “Speculative” projects where the capital can be exposed. While Enron was growing, the employees were all told to keep reinvesting their 401k plans into the company. This was based on the theory “put them all in one basket and guard it.” No employee had any ability to do the due diligence on the company, and could only listen to company propaganda. As a result, thousands of employees were left without a job and without any retirement money.

Diversification also comes in a number of ways. You can have asset diversification, i.e., stocks, bonds, real estate. You can have class diversification, with high cap, low cap, mid cap or apartments, houses, land. You can also have regional diversification, such as houses in Texas, Florida, California and Oklahoma. Another diversification is corporate—having your money spread over a range of managers so no one person controls the entire amount.

How are your assets allocated? What percentage? Which classes?

Clinton Swaine is the founder of Financial Frontier, an educational company that presents powerful experiential games and programs designed to accelerate business, professional, financial, and personal growth. To find out more about attending any of the variety of courses, visit http://www.FinancialFrontier.com.

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