Diversify Your Income Sources Not Just Your Investments and Assets

Don't Just Limit Diversification to Your Investments and Assets

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Everyone advises you about diversifying your investments, but few people seem to talk about the equally-as-important job of diversifying your income sources to create passive income. If you want to enjoy financial independence, this should be on the top of your list. It's closely related to a concept called The Berkshire Hathaway Model—taking a two-bucket approach to your personal finances, and it's not something you should brush off. 

It can mean the difference between sailing through times of economic catastrophe without so much as breaking a sweat or losing a single night's sleep or having your hair fall out from worry as you try and make it through the day, fearful of how you're going to put food on the table.

The Importance of Diversifying Your Income

When you first start out on your journey to investing, it is likely that most, if not all, of your household income will come from your primary job. That is, you sell your time in exchange for money. How much you earn per hour depends upon your skills—your hourly rate will differ depending upon whether you are a doctor, construction worker, nurse, janitor, or professor because of supply/demand considerations. This is a perfectly satisfactory state of affairs ... at first.

It is not a state of affairs with which you should be content for long. It's dangerous to rely on one or two employers to support your household's income needs. Although this goes against conventional wisdom, which tends to focus on labor as the primary mechanism for economic security, make no mistake: Job security is an illusion.

In fact, some would go so far as to say a talented small business owner who has the flexibility to enter new markets or adjust his cost structure, provided he or she has the financial knowledge to make wise decisions, is in a far less risky situation than a school teacher who could be laid off due to budgetary concerns despite the potentially higher volatility of cash flows. 

The reason? If the teacher loses his or her job, there are no new funds coming in the door to buy groceries, pay for gasoline, or build wealth. If the business owner has grown the business in an intelligent way without over-reliance upon a single customer, vendor, industry, sector, or market, he or she should always have enough funds to enjoy a good standard of living.

Diversify Your Income for Tough Times

Working to diversify your income sources is important to your investments because it is often people who have been laid off or who have experienced a substantial pay cut who are forced to dip into their retirement accounts. They pay early withdrawal penalties, capital gains taxes and income taxes, and fees (not to mention the loss of decades of compounding that could have occurred if your money remained safely in a 401(k), 403(b), Roth IRA, Roth 401(k), SEP-IRA, Simple IRA, Traditional IRA, or comparable retirement account). It is telling that during the Great Recession of 2007-2009, some of the most popular pages on the Investing for Beginners site had to do with hardship withdrawals from 401(k) accounts and ways to avoid the early penalty fees and taxes associated with tapping into an IRA before retirement age. This wasn't a problem in the older, pension-based American retirement system; even if you were hungry, you couldn't dip into your future pension payments and put your retirement at risk, but those days are long behind us. Many Americans, for better or worse, are little more than a phone call away from being able to raid the proverbial piggy bank when times get tough, downside and all.

Example: Pitfalls of Not Diversifying

Two particularly famous examples involve lottery winners and sports stars. Due to an unwillingness to diversify their income sources by using their lottery winnings to accumulate productive assets, lottery winners go bankrupt at the same rate non-lottery winners do. They spend their money on depreciating assets such as cars and entertainment rather than on things that reward them with dividends, interest, and rents. Athletes are no better. Thinking their high incomes will last forever when the gravy train stops, they have no blue chip stocks providing dividend income for them. They have no real estate investments producing rents for them. They have no bonds showering them with interest income. As a result, an estimated 78 out of 100 NFL players are typically in financial distress within two years of retiring. For the NBA, the figure is 60 out of 100.

Ways to Diversify Your Income

Here are a few general guidelines for diversifying your income:

  • Diversify your income by asset class
  • Diversify your income by sector and industry
  • Diversify your income by correlated risks
  • Diversify your income by geographic region
  • Diversify your income by country, political regime, and currency

Doing so offers many mathematical benefits aside from mere risk reduction.

An excellent example of diversifying income sources involves a prominent attorney who built a legal practice, used his earnings to develop a locally famous ice cream business. Every summer, the community looked forward to it being opened, with cars stretching around the building as people showed up for their favorite treat. The business itself was simple and required almost no oversight, operating from a tiny stand-alone building in a parking lot of a major discount retailer.

Construction company owners have used their expertise to develop car washes and storage units for their personal portfolios, providing them a stream of earnings at times when the construction business declined due to economic troubles. A banker might buy up laundromats, farmland, and shares of a gun manufacturer, all to pump income into his life aside from the bank. Some people have even bought a famous artist's song rights, enjoying royalties that arrive unexpectedly. 

Singer-songwriter Dolly Parton has built one of the biggest net worths in all of entertainment by diversifying her income. She used her publishing profits to acquire, rebrand, expand, and grow a hotel, resort, and theme park in Tennessee. Despite starting with nothing and never going to college, it's made her wealthier than the Queen of England, her personal assets estimated at between $450,000,000 and $900,000,000. She even owns restaurants in Missouri. Her secret is avoiding what she doesn't understand. She feels more comfortable with real estate than stocks so she largely doesn't buy stocks. That's okay. You can get rich without owning stocks.

The key when diversifying your income is remembering to never invest in something you don't understand. Diversification does not mean throwing money into investments you don't understand. How you will diversify will depend upon a number of factors including 1.) your personal interest, 2.) the economy at the time (some assets will be cheaper than others due to the cyclical nature of capitalism), and 3.) the percentage of your income you are able to devote to growing your investments.