This article is an excerpt from the Shortform book guide to "Your Money or Your Life" by Vicki Robin and Joe Dominguez. Shortform has the world's best summaries and analyses of books you should be reading.
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Do you know how to diversify your portfolio to strengthen your financial security? Do you need some direction with asset diversification?
To preserve a steady passive income over time, consider implementing some of the following ideas for diversifying your portfolio. You also could benefit from asking yourself seven questions (found at the end of this article) about asset diversification in your situation.
Read on to learn ways you can diversify your portfolio.
The 4 Options to Consider When Diversifying Your Portfolio
There are plenty of options for investment. It’s rare that all asset classes, or types of investment instruments, will be growing in value at the same time. Diversifying your portfolio, or investing capital in a variety of asset classes, allows you to preserve a steady passive income over time.
These are the main asset classes:
- Fixed Income (certificates of deposit, bonds, etc.)
- Stocks (index funds, mutual funds, etc.)
- Real Estate
- Commodities (agricultural products, minerals, oil and natural gas)
- Foreign Currencies
- Green Energy
- Peer-to-Peer Lending
Tip #1: Alternative Bonds
Though treasury bonds are not as high-yielding as they used to be, there are two other bond options to consider that generally have higher interest rates:
- Agency bonds: invest in a specific part of the government you care about, like agriculture.
- Corporate bonds: a bond issued by a corporation.
Tip #2: Low-Cost Index Funds
Low-cost index funds are the go-to asset diversification option for many seeking financial independence. They’re designed to follow bond market or stock market indices using passive management. Minimal trading is a built-in, low-cost feature.
Index funds come with combinations of 3 characteristics. Mix and match to diversify your investment portfolio:
- Stocks or bonds
- Domestic or international
- Small, medium, or large
Choosing funds with different sets of characteristics decreases your risk. However, there is always risk. Because stock market funds fluctuate with the market, they’re riskier than bond funds. In the history of the US, there have been multiple major market downturns in which it took decades or more for the market to recover. Young people like investing heavily in stocks but may not realize that they’re putting their capital at risk. Bond funds are less risky—if a crisis hits, you only risk dropping a percent or two.
Individual Retirement Accounts (IRAs)
Employers may offer low-cost index funds to help you save for retirement. IRAs (“individual retirement accounts”) often have low-cost index fund options.
If your employer offers a matching program, go for it—you’ll expand how much money you invest.
You can still enroll in these kinds of funds even if your employer doesn’t offer one. Opening an account with a company like Vanguard or Fidelity is similar to opening a bank account, but the returns are better.
Tip #3: Real Estate
Real estate is a popular way to diversify your portfolio. Buying a single-family home or multi-family dwelling is a great investment opportunity. If you rent out part of it and make it your home, your tenants effectively pay you to live there.
The two main downsides to homeownership are that it’s not easy to access the money quickly if needed, and there are considerable costs, like taxes.
Ask these three questions to select an appropriate real estate investment:
- Do you like the location well enough to consider living there or maintaining the house for the next few years or longer?
- Is the property value predicted to go up over time?
- How much in expenses do you expect? This includes taxes, insurance, utilities, etc.
A Caveat on House Flipping
Some people like to buy homes, fix them up, and sell them for a higher price. This strategy can work well while you’re building up savings, but isn’t a great long-term investment strategy for financial independence because it’s risky—you can’t always make a profit, and it may drive the gentrification of a neighborhood by selling at a high price that displaces local residents.
Tip #4: Local Lending
To add a community dimension to diversifying your portfolio, connect with organizations that pair investors with small businesses looking for loans. For example, you could lend money to a local bakery and ask for the principal and five percent interest back once they’re up and running.
Evaluating Investments
Ask these questions when deciding what to invest in:
- Does it fit my risk tolerance?
- Does it fit my values?
- Does it help diversify my portfolio?
- How easy is it to buy and sell?
- Will it offer the income I need?
- When can I access the income associated with it?
- Will I have to pay local, state, or federal taxes on the income it produces?
When you diversify your portfolio, you have a better chance at reaching the level of financial freedom that you desire.
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