DIVERSIFICATION, it’s one of those words that some of us may hear in passing and don’t give much thought. It is one of those buzzwords, one of those ‘should do’ items on our list. Over the series of the next three posts, we are going to talk through the three different types of diversification that I discuss with clients with regards to finical planning. Most of the time when I refer to diversification in client meetings, the first thing that comes to mind is investment diversification. This is the run of the mill stuff you will read in finance magazines and hear on the morning show of your local cable channel. This is the easy part. Well, not that easy, but this is our expertise and where a majority of wealth managers will focus. If you think about this, it makes sense. If you recall one of our first visits together as a client you may recall this masterpiece:
You will recall that I ask you to imagine you are in the North Loop area of downtown Minneapolis in one of those beautiful brick and timber, renovated warehouses. However, the elevators have not been updated as a nod to the vintage character. You are on the 14th floor and you have the choice between two elevators as illustrated above (by a talented artist ;)). The elevator on the left has one thick cable. The elevator on the right has 6 cables, not quite as thick but very sturdy and thick enough. Which do you choose?
I would hope you choose the elevator with 6 cables, unless you really enjoy living on the edge. If the one cable snaps on the elevator on the left, you are in for a ride to the bottom. If the cable on the right elevator snaps, the 5 other cables hold us up long enough to fix the broken cable.
This same concept applies to investment diversification. If we have all our money invested in ONE company, that is in ONE industry, in ONE location, in ONE sector with ONE management team, we are choosing the ONE cable elevator. If that ONE company has an unforeseen event (compromise of identity of customers, security breach, fraud, etc.), then we are at the risk of riding that ONE elevator down to the ground. By now, I am sure the word ‘Enron’ has popped in your head. There are, unfortunately, more examples of this scenario as well.
There is a caveat to this example. I personally work with many entrepreneurs and love the experience in helping these individuals. As an entrepreneur, it often requires that they ‘bet the farm’ to succeed – not always, but often enough. The big difference is that they are essentially betting on themselves rather than another management team. If the idea or company fails, then they shoulder the responsibility and the opposite is true if they succeed. While this may seem counter-intuitive to the concept above, this is all more the reason for entrepreneurs to diversify their assets outside of their business.
The next post will discuss the next diversification concept with a fun, real world example that may ring a bell for many of us.