I am going to veer off from my usual credit card related comments and talk about what I think is an important but often overlooked debate in the world of money management and personal finance.

The common opinion and theme among those in the financial advisory industry is that diversification of portfolio will lead to improvement in portfolio performance (risk versus return), and more efficient asset allocation (portfolio along the efficient frontier). While this is certainly true and almost all instituition manage their money this way, I think some modification is needed for those looking to make a big leap in their wealth levels.

What if you are making say $70,000 a year, have $300,000 in your portfolio, but somehow are thinking of making the big leap to have a networth of $5,000,000 (using this number as an example)? How can you accomplish this?

Well, one thing is for sure : regular savings into a diversified portfolio isn’t going to cut it. Most wealthy individuals who achieve a networth of $5mm or more do so by owning their business, having concentrated stock positions, investing in multiple real estate, created or sold a business. If you look at their portfolio, they got wealthy by putting the bulk of their time , energy and money in ONE particular business.

So how does one resolve the diversification dilemma if you want to make a big jump in your wealth levels. Should you abandon portfolio diversification? Certainly not. What you may have to do is to allocate a certain amount of resources in the pursuit of your targeted wealth level. That certainly involves time and money, whether it be time focused on your career to get more company options and stocks, setting aside a portion of your portfolio for high risk high return investments, or investing in your own business.

As an example, rather than investing your whole investable assets in a diversified portfolio of bonds and equities, set aside a percentage for more concentrated investments that can turbo boost your wealth. It may be in real estate, well researched stock ideas, investment to start a new business, or simply hold on to your company’s stock grant rather than diversifying everything (assuming you are bullish on your company).

What percentage of your investable assets should you set aside for your “investments to boost your wealth to a new level”? It really depends. Firstly, make sure you have emergency funds set up, adequate insurance to cover any unforseen events. Sit with a wealth manager and develop a diversified portfolio. Set a aside a percentage of your investable asset that you can afford to lose to pursue your investments that is supposed to really make you wealthy. For the example above, maybe setting aside $30,000 or 10% of the portfolio is enough, or it could be higher depending on your comfort level.

This also works the other way. If you have acquired a high level of wealth through concentrated “investments” – be it real estate, company stock or your own business, at some stage, you have to diversify some risk and go into “capital preservation” and “conservative growth” mode. What percentage? Well, once again, it depends on your situation.

It is important not to get fixated with either philosophy. What do I mean? If you fit the profile like the example above – earning $70,000 a year, have a portfolio of $300,000, you should be really thinking hard on how to bring your networth to the next level. You will wasting time on things like spending hours searching for the right mutual fund, debating over topics like index funds versus manged funds, or should you or should you not use a financial advisor and pay some fees. Get your finances in shape and invest a portion of your portfolio in an area that can potentially take your wealth to the next level. Remember, a diversified portfolio is meant to earn around 7% to 12% a year. Concentrated investments are meant to earn much more.

The reverse holds true for the those who have achieve a significant level of wealth. For example, you will often hear that real estate investors do not believe in the “stock market because real estate investments are superior”. This kind of thinking isn’t right as well. What happens when you have made an enormous amount of wealth. Prudence suggest you should set aside some of it in a diversified portfolio to preserve it. I find that more successful business owners realize this because they know it is so difficult to achieve their level of wealth. They put in years in their business, so they realize they have to preserve that wealth as well.

To sum up, there is a place for both diversification and concentrated investments in your portfolio. The percentage will vary depending on your wealth levels. Avoid the mistake of clinging on to either extreme view or position.

This entry was posted on Saturday, January 13th, 2007 at 03:59 and is filed under News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.