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5 Types Of Diversification Your Financial Advisor Won’t Mention

7 September 2009 3 Comments

Diversification is a financial advisor’s favorite word.  It’s the commonly accepted strategy for everything financial.  Diversify and you’ll make lots of money and minimize your losses (yeah, ok).  Anyways, there are many types of diversification that are thrown around frequently.  When it comes to investing, you can diversify by geography, market cap, industry, etc.  This article will discuss 5 types of diversification that you typically don’t hear discussed.

#1 – Income Diversification

The purpose of diversifying is to minimize risk.  Don’t put all your eggs in one basket, right?  It’s interesting how we never consider our income in this regard.  How can we diversify our income?  I only have enough time and energy to work for one job!  While this may be true when you view a job as a 40-plus hour a week commitment, perhaps it changes when you consider more passive income streams.

The types of income streams that I am interested in are ones that I can generate and work on during my time outside of my main job.  For younger people, online income streams are your best bet.  Whether it’s creating a website or doing some freelance writing on the side, I encourage you to investigate what might work for you.

Dividends can definitely provide an income stream, but until you are retired (or really need them), I typically recommend reinvesting dividends to build your investments.  Additionally, you will need lots of money invested to generate dividend income  you can live off of.

Recommended action: Invest your time and energy into the development of some online income streams

#2 – Reserve Currency Diversification

In the first of several “politically-oriented” types of diversification, this one is what I call Reserve Currency Diversification.  Many of the benefits that the American economy enjoys are due to the status of the U.S. dollar as the world’s reserve currency.  For example, we are able to continually expand our debt to the world because of this status.  Because we are talking about mitigating risk, what if at some point, we lose our status as the world’s reserve currency?

It would be an ugly day in our history if and when we lose the reserve currency status.  It would severely impact our ability to finance our stimulus packages and government programs.  Interest rates would have to go up to entice investors to buy our debt.  Higher interest rates would have a largely negative impact on our economy, especially if it happens during a recession-like period similar to today.

Recommended action: Get exposure to assets that will do well if the U.S. dollar loses value.  This includes gold and other commodities.  Also, consider owning the UltraShort 20+ Treasury ETF (TBT) which will do well if interest rates rise.

#3 – Political Diversification (Where Your Assets Are Held)

It’s sad that as a citizen of the “beacon of freedom” that is the United States, we have to consider political diversification, but we do.  Especially, if you are very wealthy.  Targeting the rich is very common and politically popular these days.

In a severe crisis, our government can do things we have a hard time comprehending.  Back in the 30’s, government confiscated gold from its citizens.  Yes, the American government did this.

If we had a currency crisis (see diversification type #2), our government could put in place currency controls and prevent us from exiting the U.S. dollar.

Also, I’m a big proponent of investing in China, but it’s important to recognize the uncertainty with the Chinese communist government.  While the Chinese government is more business friendly than the American government in my opinion, there is still a level of risk there that needs to be monitored.

Recommended action: If you are very wealthy, consider holding assets offshore and in another currency or in a precious metal like gold.

#4 – Political Diversification (Government Involvement)

In the second case of political diversification, we are focusing on how involved government is in the economy.  How regulated are specific industries?  It’s important to understand government action in a specific industry and how that will impact our investments.  What industries apply here?  Banking, energy, health care, autos for starters.

Recommended action: Make sure you are invested in sectors outside the major sectors in which the government is heavily involved.  Also, invest in companies that do business outside the United States.

#5 – Tax Diversification

When it comes to investing, taxation is a given.  For young investors, tax laws could look entirely different years down the road than they do today.  For example, our Roth IRAs are supposed to have tax free deductions when we are eligible to withdrawal money from them.  However, am I 100% certain that our greedy politicians won’t change laws over the next 40 years to get their hands on my money some how?  No, I’m not.  Owning both a 401(k) and a Roth IRA is a good way to diversify the tax advantage.

Other things to monitor: short term & long term capital gains taxes, dividend taxation, etc.

Recommended action: If you have a 401(k), open up a Roth IRA.