“Don’t put all your eggs in one basket.” It’s a saying that goes back centuries, to at least the writing of the novel, “Don Quixote.” Author Miguel Cervantes (1547-1615) wrote, “It is the part of a wise man to keep himself for tomorrow, and not venture all his eggs in one basket.”
The advice rings as true today as when it was first penned in the early 1600s.
A more modern term for spreading your financial eggs around is called diversification, which also requires some explanation because there are different levels of diversification.
Here’s the class 101 version, starting with the simple to the more complex kinds of diversification. Since the stock market is always a popular topic of conversation, let’s start our discussion there before expanding the scope of other kinds of investments.
Diversify, diversify, diversify
If you pour all your money into the stock of just one company, and that company’s stock declines or the company whose stock you own goes bankrupt, you could suffer a huge economic loss.
To offset some of that risk, you might buy two stocks, say, Amazon and Microsoft. That way, you would have your eggs in two baskets. Your Amazon stock could fall, but your Microsoft might go up. Then again, if they both went down, your investment portfolio would still be in the negative.
To lessen the risk of losing money on your one or two stocks, you might consider investing in a sector fund, which is a mutual fund or exchange-traded fund that invests most or all of its assets in one particular sector of the economy. So, sticking to our tech sector theme, your fund would most likely invest not only in Amazon and Microsoft (our two hypothetical stocks), but a full basket of tech stocks, such as Facebook, Alphabet, Oracle, Intel, Adobe and many others. Or, if you think the tech sector is cooling off, you could play other sectors, which include financials, consumer cyclicals, consumer staples, utilities, energy, natural resources, healthcare, real estate, and precious metals.
But what if that one sector, where you’ve spread your investment bets across many companies, takes a dive? Then what? Well, you could spread your eggs around even more. You could buy an index mutual fund or exchange-traded fund (ETF), whose value is tied to an entire index, which includes companies from all the sectors. For example, the Standard & Poor’s 500 Index is an index of 500 of the largest U.S. companies, listed on the New York Stock Exchange or NASDAQ. This way, you’re less concerned about the performance of any one stock or even any one sector. The tech sector could be in a tailspin, but financials, healthcare, and natural resources could be going through the roof.
Buying an index is certainly another way to become more diversified than if you had just bought one or two stocks or even one or two sectors. But in the big investment picture, you would still not be that diversified.
That’s because, up to this point in our example, you’ve been invested only in stocks. What would happen to your portfolio if the entire stock market tanked? You need only look back to the 17-month bear market, from Oct. 9, 2007 to March 9, 2009 (not exactly ancient history), to see that the S&P 500 lost approximately 50% of its value.
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Asset allocation to the rescue
For many, especially those nearing retirement, that kind of precipitous drop would be a financial blow from which you might not be able to recover. Fortunately, there’s another kind of diversification available, which is known as asset allocation, where you can spread your money across not just one asset (like stocks), but several asset classes, such as stocks, bonds (fixed income), real estate, cash and other tangible assets, on the principle that various asset classes don’t always march in lockstep (correlation) with one another. While one asset class, like the stock market, goes up, another asset class, such as gold, could go down. By investing in multiple asset classes, you can avoid or reduce the overall risk to your investment portfolio.
Yet, the truth is, most Americans, don’t have a “balanced” portfolio of different assets. About half of all Americans don’t own any stocks or bonds. Rather, for the majority of Americans, their home is their largest financial asset.
On the one hand, according to HousingWire.com, homeowners, age 62 and older, now enjoy a record $7.1 trillion in home equity. But on the other hand, these same homeowners could be at substantial financial risk because of their lack of diversification. The home they own may be an asset, but it is an illiquid asset, meaning that their real estate first has to be converted to cash before it can be put to work, and that conversion process, depending on the housing market, financial markets and other economic factors, may take days, weeks, months or longer, which doesn’t do you much good if the auto repair shop where you brought your car to be fixed won’t let you drive it home until it gets paid.
Cash is king
To avoid this kind of cash crunch, you always need to keep some kind of emergency fund that you can access in a heartbeat, such as in a checking account, savings account or a money market account linked to a debit card with check-writing privileges. Your returns on any of these accounts may be minuscule when compared to the yields produced by investing that same money in stocks, bonds or real estate, but cash is liquid, meaning you can access it quickly, easily and electronically when you need it to pay your doctor or mechanic on time.
Otherwise, how would you pay for a sudden expense if life throws you a curveball? Call a relative? Call a friend? Ask for an advance on your paycheck? What if you’re already retired? Even if you owned a million-dollar house, it wouldn’t do you much good if you needed the money today or tomorrow.
What you would be facing is not an asset squeeze (after all, you own a home with equity), but a liquidity squeeze. Keep in mind that most companies don’t go bankrupt because they don’t have assets or even because they lose money. They go bankrupt because they lack liquidity (easy access to cash) to meet their daily obligations. When the widely-admired investment bank, Lehman Brothers, declared bankruptcy in 2008, it had $639 billion in assets. It didn’t have a money problem. It had a cash flow problem. Their assets lacked adequate liquidity. It had the hose, it had some water in the hose, but it had a kink in the hose.
So, if your home is your biggest asset, as it is for most seniors, ask yourself if you need to be more diversified so that you can weather a financial emergency and avoid a life-altering cash crunch. Think of this cash not as an investment, but as an asset or necessary buffer that you always have at the ready to protect you from a financial crisis. Creating two very different kinds of assets from one (in this case your home), which have different levels of risk and return, is a key principle of diversification.
The anti-cash crunch plan
Whether you run a company or a household, maintaining liquidity has to be a primary consideration. You have to make sure you have sufficient money available each month, from your salary, pension, Social Security, investment accounts and other financial sources, to match your monthly cash outflows.
But if you lack many of these financial resources or find they are inadequate to meet your monthly expenses, then you need to consider another source. And if that source is your home, you need to look at ways to make it more liquid.
Here are some approaches for tapping the home equity you’ve built up:
Downsize: Sell your home, and either rent or buy a home that is more affordable.
Upside: After the sale, you’ll have more money in your pocket that you can put to work in a variety of ways.
Downside: If you like where you live, your move to different digs could be very disruptive.
Get a cash-out refinance, where you replace your current mortgage with a new mortgage that offers better rates and terms.
Upside: You can apply the savings from your more affordable mortgage to help you meet your monthly expenses.
Downside: This strategy doesn’t make much sense if your new mortgage rate is higher than your current one.
Apply for a home equity loan, which allows you to pull equity out of your home in the form of a lump-sum cash payment to be repaid over a set period at a fixed interest rate.
Upside: Use it to pay off higher-interest debt to help you reduce your overall monthly expenses.
Downside: Even though it’s a second mortgage, if you can’t repay the loan, you could lose your home. Also, if the home declines in value, you could end up owing more on your home than it’s worth.
Apply for a home equity line of credit (HELOC), where you’re borrowing against the available equity in your home and the house is used as collateral for the line of credit.
Upside: Borrow as you need the money and pay interest only on the amount withdrawn.
Downside: The lender can pull the line of credit, as often happened during the financial crisis.
Apply for a reverse mortgage, which pays off your current mortgage on the home that you continue to own and live in while providing you with cash disbursements in a payment plan that you select.
Upside: There are no mortgage payments and your disbursements can’t be pulled or reduced, even if housing prices were to decline (but you must maintain your home, property taxes, homeowners insurance, and comply with your loan terms). Loan approval is based on your ability to live up to the loan terms, not necessarily on your FICO score, employment status or other financial factors that are typically used for granting traditional loans. Your loan also does not have to be repaid until you leave the home or do not comply with the loan terms, further helping you improve your cash flow for meeting everyday expenses or expanding your emergency fund.
Downside: As with a traditional loan, if you don’t live up to your loan terms, you could default on your loan, which could lead to foreclosure. Also, you can’t qualify for a reverse mortgage until you’re 62 or older.
Born in the same 16th century as Cervantes, the English military leader Oliver Cromwell (1599-1658) also expressed the importance of having many options available so that you can always react to changing conditions — a state of readiness heightened by the principles of diversification and asset allocation.
As his troops were crossing a river in preparation for battle, Cromwell shouted, “Put your trust in God, but keep your powder dry.”
That appears to be good advice for any century.
The following information is intended for educational/informational purposes only. Before investing, you should always consult with your financial advisor, accountant or other trusted financial professional.