WHEN it comes to earning, accumulating and growing wealth, there is a natural tension between concentration and diversification.
For many successful entrepreneurs, the high profit margin on the annual revenue of their businesses, which is linked to their return on capital employed, is why they sneer at typically lower investment portfolio returns.
These individuals often choose, understandably, to concentrate their economic activities in their own businesses.
The advantage of opting for wealth concentration is that for as long as good times last, these business owners will thrive. The downsides, though, are obvious.
Taking the path of pure wealth concentration means that (by the Law of the Excluded Alternative), the superhighway to wealth through diversification is shunned. You see, it is a binary choice like 0 or 1, yes or no, up or down.
HOW MANY BASKETS DO YOU HAVE?
Each of us, either through active choice or lackadaisical inaction, puts all our economic eggs, so to speak, into just one basket (concentration) or in two or more baskets (diversification).
So mentally scan your past and present economic decisions. Have you in the past and are you now pinning all your hopes on a single streaming inflow of cash from a business you run or from your job? Are you wholly dependent on the active income that business or job brings in?
If your answers are ‘yes’, what will happen to your family when you stop working and cease bringing in an active income?
For everyone who takes financial planning seriously, the only solution is to create passive income streams.
Toward that end, I often tell my financial planning clients, “Thank God for EPF!”
All of us who are forced to contribute to EPF and the wise ones among us who don’t HAVE to but who proactively choose to do so anyway are generally in better shape to handle an eventual future marked by forced unemployment than those who don’t have an EPF account.
If we think about the simple process of how EPF collects our money, we will grasp two factors in long-term personal and family economic survival:
First, either through the operation of law or personal choice, when we contribute to EPF, we exercise delayed gratification by spending less than we earn.
Our core intent is to give up some good old-fashioned consumption today for the needed capacity to at least partially fund our retirement tomorrow.
Second, the growth we enjoy on our personal unspent capital that flows into EPF comes in the form of the annual snowballing, compounding dividend that EPF pays us.
For instance, EPF’s most recent 2016 dividend of 5.7 per cent is a form of passive income that will help us survive in retirement.
SAVING FOR A RAINY DAY
But all of us, of course, wish to do more than survive in our later years. We yearn to thrive in retirement.
So we should arrange our affairs to transition from “working for our money” to “having our money work for us”.
It is thus wiser for us to select diversification over concentration because just as there is safety in numbers when traipsing through a dark alley in a bad neighbourhood, there is greater risk mitigation when we diversify our investments across different asset classes, geographic regions, and across the timeline (meaning we should save and invest steadily over many, many years).
The late investment icon Sir John Templeton once declared: “Diversify. In stocks and bonds, as in much else, there is safety in numbers.”
Templeton knew what he was talking about. Still, it is difficult to ignore the powerful, siren call of concentration.
After all, you don’t need to be a business owner to pick that hyper-focused path; even employees in specialist fields like medicine, law and engineering sometimes behave as though their well-paid work will last forever and is all they will ever need for their long-term financial needs.
In my opinion as a financial planner, a safer path for my clients and workshop audiences to tread is to focus on becoming the best they can be at their work so as to elevate their capacity to earn more money with every passing year. That’s maximising active income!
As smart people grow their active income by investing in themselves through books, journals and seminars, the absolute smartest among them simultaneously commit to a gradual transitioning of their total income profile (total income = active income + passive income) so that with each passing year their ratio of passive income to total income rises.
Snowballing passive income arises from decisions made by the savvy to spend less than they make and to save and invest the difference for a long, long time.
It is a simple formula for lifelong financial success.
So when my clients ask me to help them invest their excess funds into various asset classes in different countries across a span of years – ideally decades – I applaud them for steering onto the diversification superhighway.
Templeton admitted once that: “In my 45-year career as an investment counsellor, humility did show me the need for worldwide diversification to reduce risk.”
Nurturing humility to recognise that diversification can help us grow and stay wealthier might be a phenomenally precious lesson for us all.
Rajen Devadason, CFP, is a Securities Commission-licensed financial planner, professional speaker and author. © 2017 Rajen Devadason