Dare to Change Life Coaching & Mentoring

Tag: risk

  • To Diversify OR NOT to Diversify PART 2: the Danger of Over Diversification and How to Avoid It

    To Diversify OR NOT to Diversify PART 2: the Danger of Over Diversification and How to Avoid It

    When it comes to diversification, some beginner investors get confused about the degree of diversification they need to maintain in their investment portfolios. After all, there are SO many choices out there!

    And while diversification is a smart risk management strategy (and I talked about its benefits at length in the PART 1 of this Wealth-building mini-class series), this strategy must be approached wisely.

    There is an old saying: “Everything has a front and a back.”

    I find it true.

    So, today I want to share with you the “back” of diversification, which is Over-diversification so that you’ll be aware of what NOT to do.

    Over-diversification is a common mistake that can significantly decrease the returns from your investments compared to the risk of losses in your portfolio that you mitigate with the diversification strategy.

    Because most investors are aware of the harmful effects of under-diversification, many mistakenly believe that the more diversification the better. This concept is false and can lead to significantly diminished returns in your investment portfolio.

    It’s like getting natural vitamin D from the sun because it’s  essential for your optimal health, however, receiving over-dose of the sun radiation through the extended exposure can lead to serious health issues.

    How the Over-diversification happens?

     

    Over-diversification happens when the number of investments in your portfolio exceeds the level where the loss of the expected return from your investments is greater than the benefit of reduced risk from the diversification.

    When you add investments to your portfolio, it lowers your risk of loss but potentially lowers the expected return as well.

    For example: Let’s say, you own 1 stock instead of 1000 stocks. If you own just one well-performing stock, your expected return (gain from investing in this stock) is very high but so is your risk. Your entire portfolio performance will depend on that one stock.

    In Part One of this mini-class, I shared with you my story when I invested all retirement funds into the stock of the company I worked for at that time. This portfolio performed fabulous… until the stock market crashed.

    SO, you I hope by now you clearly see the benefits of going from one stock to five, or from five stocks to twenty.

    Each time you add a new investment to your portfolio, it will lower your risk of experiencing devastating losses. However, after a certain point, it will also lower the expected return from your investment portfolio.

    For example, if you own 1000 stocks, you will eliminate unsystematic risk (risk associate with a particular company or industry), but, most likely, your portfolio will not contain the best performing stocks and the highest quality companies.

    I pretty much can guarantee that a portfolio of 1000 stocks, whether owned individually or through Mutual Funds or ETFs (Exchange Traded Funds), will contain a wide range of opportunities – from best to worst. There will be some great picks (companies with phenomenal performance and growth potential) and quite a few losers.

    In other words, at some point in your diversification efforts, you can reach the number of investments where the benefit of risk reduction is smaller than the decrease in expected gains.

    How to Decide on the Optimal Diversification

     

    What I want to bring to your attention today is that owning only 15-20 great stocks in your portfolio, which are diversified among a variety of industries, would be a much better choice than owning 20 great stocks plus 980 mediocre or poor performing stocks because these 980 will pull down your portfolio’s performance.

    That’s why over-diversification leads to below average or even poor returns in your portfolio. And you may fall into this “over-diversification” trap by simply holding a few mutual funds, ETFs, and index funds that are over-diversified and focus on quantity instead of quality.

    How to Diversify Your Portfolio

     

    I strongly believe that diversification is not simply a numbers’ game.

    As I demonstrated earlier, the number of investments in your portfolio does NOT determine how risk-prudent and performance-optimized your portfolio is.

    The trick to successfully diversifying your portfolio is owning investments that play different roles in your investment portfolio.

    Just like having a team in your business where every team member has a specific role in order to achieve best possible results in your business, your investments need to have different roles in order to achieve best returns in your investment portfolio.

    Some investments meant to focus on Growth, others on Income, and yet others on Value (good companies that are going through transition and are currently undervalued).

    You can also diversify your investments by companies’ market capitalizations (small-, mid- and large- caps). And you can choose to own domestic and international companies from different market sectors.

    But to really optimize your investment portfolio, I invite you to consider adding alternative investments into the mix like real estate or commodities. Because, historically, alternative investments’ performance doesn’t highly correlate with traditional assets like stocks and bonds.

    When stocks and bonds are moving straight up or straight down, alternatives can move diagonally. It’s like taking the escalator instead of the elevator to your financial goals. With alternative investments in your portfolio, you may be moving a bit slower toward your financial goals but you’re less likely to get trapped between floors.

    The Bottom Line

     

    We talked a lot about the importance of diversification in the Part 1 of this mini-class series. However, you’ve got to be aware of the dangers of Over-diversifying your portfolio.

    The optimal diversification of your portfolio would be to own a number of individual investments that are large enough to almost eliminate unsystematic risk but small enough to focus on the best-performing opportunities in the long term.

    For more resources on various financial topics, check this page on my website:

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    To your Health, Wealth, and Freedom!

     

  • 5 Tips on How Couples Can Deal with Differences around Money and Investing

    5 Tips on How Couples Can Deal with Differences around Money and Investing

    Do you fight with your partner every time you talk about money?

    Or do you have open, candid “money conversations” with your partner?

    Or do you avoid talking about money with your partner so you can avoid fights and frustration?

    Research has shown that couples that avoid fights about money, often end up having less wealth and not being prepared for a successful retirement.

    No one wants to fight, of course. Howevere, money is the #1 thing couples argue about. And you probably heard that fighting about money is often an early predictor of divorce.

    So, why would couples get sucked in into the argument about money when it causes so much stress, tension, and destruction?

    While nobody wants conflict, avoiding communicating and working through disagreements with your partner can hurt the relationship and put your future financial security at risk.

    I’ve met many women who shared their frustration about not being able to “talk money” with their partner in a constructive and candid way.

    “I love my husband and don’t want to get into big arguments over money. So, I stopped talking about money with him all together. And now I have my secret money accounts.”

    “I was sick of fighting about money. Now we both avoid these conversations.”

    “We can’t ever agree when it comes to investing. He does his thing and I do mine.”

    While many couples default to “not talking about money”, this solution usually comes back to haunt them.

    Here’s why.

    Men in a couple tend to have higher confidence and higher appetite for risk than women.

    Because men usually have more risky investments and higher balance, women tend to keep substantial amount of cash in case of  emergencies.  In other words, to balance her husband’s high-risk investments, a wife often compensates it by keeping a high balance in FDIC-insured bank accounts, which provide safety but little or no return. This allows her to sleep at night and avoid arguments.

    While it may work for some couples, this strategy may cost couples loss of opportunities in the end. If they invest $100,000 in a super-safe bank account earning 0.5%, rather than a conservative balanced index fund that may have earned 3.5%, they would have passed up 3% per year in earnings for each year the funds are invested.

    On a $100,000 account, that’s $3,000 a year, and $30,000 over 10 years (not including reinvested dividends and capital gains.)

    On the other hand, husband’s high-risk investing strategy may lead to significant loss of family wealth that he is trying to build by taking higher risk.

    I believe, there are better ways to managing money as a couple than fighting over it or avoiding talking about money. Here are a few tips to get couples started on the road to creating wealth together:

    1.  Communicate

    I believe in candid and transparent communication in the relationship. Have a candid ‘money talk’, be open about your concerns, and share your preferences when it comes to investing ideas. Don’t avoid ‘difficult conversations’ – find a way to have them in a constructive and respective way.

    Work through your financial conflicts (rather than fighting about them or avoiding them altogether). If this seems daunting, you may consider talking to a financial planner, even if you are a do-it-yourself investor. If you can’t seem to work through financial arguments and have very different risk tolerance with your partner, get independent help to work through your differences and overcome communications’ challenges.

    1.  Set financial goals as a couple

    Determine the return you’ll need to get on your investment in order to meet your financial goals. You may not need to take on additional risk to reach your financial goals. Calculate your annual lifestyle spending to determine what your rate of return on your investments needs to be, based on the amount you are currently saving. Don’t take more risk than you need, however, don’t be overly conservative either. Your investment returns must be adequate to meet your goals.

    Set goals as a couple and develop investment strategies around those goals. For example, are you going to invest in the stock market?  Rental real estate? In your growing business? If so, what percentage of your total assets you want to invest in each asset allocation?

    If one of you wants to trade or invest in high-risk investments, limit the amount you allocate into high-risk investments and integrate these investments into your overall plan.

    1.  Compromise

    I like to remind women that they should “pick their battles.” While some things are definitely worth fighting for, some things aren’t worth the argument. Your financial future is definitely worth fighting for.

    When you have a “money talk”, listen to your partner, really hear his point of view when it comes to investing family money, and see if there is a way to find a common ground. Willingness to compromise is important for the healthy relationship. However, never compromise on your core values in life.

    For example, if Freedom is your core value and you feel that your current employment is totally draining your energy and health, although paying you a very good salary, leap your way out of this situation even if your partner feels it’s wrong for your family finances.

    When you force yourself to do something that you utterly resist, you compromise on something that is deeply important to you and can make yourself seek.  Money is important, but your health and vitality are more important than money.

    1.  Dream together

    Your money talks don’t need to be only about bills you have coming up and debt you need to repay. These conversations do need to take place, of course. But you can also share your aspirations that require you to save and grow you money – maybe a new house, or a trip, or a business that you’re passionate about. Whatever it may be – dreaming together, having common goals will help you get closer and inspire you as a couple to work toward your goals.

    Do the “Five-Year Exercise.” If you only had five years to live, what would you like to do, have or experience?

    Don’t overthink or censor yourself. Just start writing it down. If you are married or in a relationship, each of you should write your lists separately. Then, as a couple, choose what you’d like to do, have or experience, both together and individually. It’s hard to fight or argue about money when you are working together toward important goals. Don’t give up on your dreams!

    1.  Become Financially Empowered

    Invest in yourself – let go of your inner blocks, become equipped with knowledge about strategic investing. Although having a MBA in finance might be nice, you don’t need it to be financially successful. Having a solid base of financial knowledge will take you a long way. Couples who both understand financial fundamentals, can make better financial decisions, especially when they make them together.

    Besides, it’s quite likely that at some point you may be 100% responsible for your own investment and money decisions. Now is the time to upgrade your skills and knowledge about savvy money management and investing.

    To Your Health, Wealth and Freedom!

    Millen

    p.s. Download my wealth building tips-packed book “A Shift Toward Abundance” HERE