With the dip in the broad market over the past couple of weeks, it feels like prescient timing for that age-old reminder about diversification. Or, as your dad put it, not having all your eggs in one basket.

I’d like to go a step further here and talk about why diversification is not just for your portfolio. In fact, if all you ever diversify is your portfolio you'll miss the forest for the trees and end up exposed to both greater levels and more types of financial risk.

While diversification in your portfolio is extremely important – I’ll cover that too – there are other types of diversification you should be aware of if you're trying to optimize your total financial picture.

Portfolio Diversification

Back in 1952, a young man named Harry Markowitz (he was 25 at the time) crafted the dominant hypothesis behind portfolio construction called “Modern Portfolio Theory”. In layman’s terms, Markowitz proposed that there is an “efficient” combination of investments for every individual, adjusting for each person’s level of tolerance for risk.

The theory is now ubiquitous and has spurred the concept of portfolio diversification to evolve into a household term and an industry norm. Amazingly, this is still the predominate theory of portfolio construction being used today.

We know today there are definite holes in the theory, but so far no one has been able to construct a better (mathematical) explanation for how to build a portfolio (or why the markets do what they do).

I’ll make sure to touch on this phenomenon in a separate article; in summation there are market “anomalies” which Markowitz’s theory does not properly explain or account for. Markets are not math - markets are a group of irrational human beings. No mathematical model can perfectly capture our irrationality, thus every attempt to capture market performance in a mathematical theory will end up lacking to some degree.

There are several important ideas when it comes to diversifying your own portfolio:

• Consider your own comfort level for taking risk, and, wherever possible, measure it. Your adviser should be able to help you with this.

• Stick to your risk tolerance & adjust for your time horizon (fancy term for when you’ll need the money). If you need the money in 30 years, that would allow for a higher level of risk than if you needed it in 3 years. Also, don't be tempted to step into more levels of risk during "good" times or to de-risk in "bad" times.

• Construct your portfolio with different types of stocks and or funds; owning 15 different funds is great, but if they’re all “Tech” funds then you’re not really diversified.

• Re-balance your portfolio at least annually. There is much debate on how frequently to re-balance, but suffice it to say that at least annually is better than none at all. This keeps the portfolio aligned with your personal risk tolerance and “time horizon”.

Diversify your asset types

Here’s where we go beyond just the portfolio. It’s just as important to manage the composition of your personal balance sheet – that is, what you own & what you owe.

If your balance sheet becomes too concentrated in one type of asset, you are poorly diversified, and you’ve exposed yourself “unsystematic” risk. This means that you personally have taken on an increased risk of loss which is not necessarily tied to the overall “system” or economy; in other words you'll be impacted differently than your neighbors.

Just a couple of examples:

Real Estate

Kudos to those of you who are successfully playing the real estate game; those who do it well know firsthand the power it has to supplement income, provide for capital gain, tax advantages, etc. Real estate is its own “Asset Class” or “type” of investment.

What I have seen, however, is that many successful real estate investors become enamored with the process and over-commit to the asset class. It becomes almost the only type of asset they carry on their balance sheets

We all learned in 2008 that housing values can and will decrease, and aside from the possibility for loss of capital real estate has other risks such as loss of purchasing power, liquidity risk, etc.

Your Business

Similarly, many business owners plow every bit of extra capital back into their own businesses. While this is often necessary for a small business – especially early on – it does put the owner in a position where their personal balance sheet is very concentrated.

Again, we have to consider the possibility of the loss of value in the business in a market downturn or recession. Beyond that and perhaps more commonly, the biggest problem here is liquidity. This just means that most small business owners have a tough time turning the value of that business into something they can live off of and spend.

Employees can also take note on this – we see many employees who own lots and lots of stock in the company they work for. This is becoming more commonplace as RSU’s, Grants, ISO’s, Stock Bonus Plans and Employee Stock Purchase Plans grow in popularity as an employee benefit. Those things are great, but when you have the opportunity to diversify you should strongly consider doing so.

Own different types of tax-buckets

Beyond the balance sheet, it’s also important to diversify how you receive your assets when the time comes. What I mean specifically is how those monies are taxed when you withdraw them. With our private wealth clients, we always aim (wherever possible) to have multiple “buckets” of taxation.

We want more and different types of ammunition to deploy depending on what the tax environment is at the time.

For example, if you have a bucket of income-taxable money (like a 401(k) or IRA), that money will be taxed as income to you when you take it out. If it you need to withdrawal during a time where income tax rates are high (for you personally or legislatively) then we’d rather not have to draw from those types of buckets.

Conversely, if it happens to be a time of low income tax rates, then perhaps we’d like to leave our capital-gain-taxable money alone and draw from those income-taxable accounts. The idea is to be able to maneuver and adapt the environment at hand.

The most common error I see in this regard is with qualified retirement plans. Quite often I’ll run across someone who is sending their entire savings goal (say 10% of their income) into their qualified retirement plan.

Beyond the tax-bomb they’re building, they’re locking that money in for (perhaps) a very long time (age 59 ½, death, disability or other triggering event). Yes - we should take advantage of tax-savings and employer matching in qualified plans wherever possible, but as with everything else we’ve discussed, we should do this with balance in mind.

Diversify your access to money

This is one a lot of folks just totally whiff on. When making an investment into any type of asset – real estate, stock market, bond market, savings, annuities, life insurance, your business, etc – its important to consider whether that money will be liquid (immediately available for return).

If the money is not initially liquid, you’ll want to make sure you’ve got enough liquidity elsewhere before committing to the investment.

There are a couple of common errors that I run across here – again I’ll harp on my real estate investors. Over-concentration to the real estate asset class often leaves the investor in a position of very little cash on hand. You don't want to be caught with your pants down when life comes at you - and it will. For you real estate investors out there (and for anyone, really), its vital to maintain a cash cushion of at least one years’ living expenses.

Beyond that, most successful real estate investors have a reserve pool of cash available to help facilitate quick deals. Whether through an actual saving account, a line of credit, a life insurance policy loan, or something else, having cash in hand quickly can often mean the difference between winning & losing on a deal.

The other common thing I see is that people get heavily into financial products. What I mean specifically is they become over-committed to things like annuities, life insurance or limited partnerships. Products they buy where someone earns a commission.

While any of these products can serve a good and valid purpose, it’s really important to aim for balance here. Many life insurance policies and annuities can take several years to “spool” up; you won’t have access to most of your money during this initial period (usually called a “surrender charge” schedule).

In Conclusion

Consider this just a primer on overall financial diversification. As I state in most of my articles, its best to seek the help of a professional when optimizing your personal balance sheet.

If your adviser can provide a system or tool to aggregate all of your assets, liabilities, income, expenses, taxes & insurance then you’ll have a great place where you can visualize & stress test different types of investment scenarios. You’ll be able to see the whole game-board, and there is a huge amount of power and efficiency in that.

Of course (ahem, plug time), that’s what we do when we function as a Personal CFO for our clients at Jarred Bunch. Schedule a time to connect with me and I’d love to walk through it more with you: