Editor’s note: This article was first published in May 2013: the fall in property values “in recent years”, the S&P 500 rally and the comment that Spanish banks were the largest real estate sellers all describe the post-2008 market.
It is hard to agree on which diversification is best for building wealth, since there are millionaires who got rich in each of the two ways we are about to describe. One thing is beyond dispute: the highest return you can get on your money comes from starting your own company.
So far, there are two types of portfolio diversification
The first puts 60% of the money in equities (stocks), 35% in fixed income (deposits, bonds…) and 5% in cash. These percentages vary depending on risk and age.
(Read: 5 financial education tricks, where we explain some mathematical rules you should know)
The truth is that many executives and company employees who have been investing their savings this way have managed to multiply their money nicely and reach financial freedom over the years.
The second diversification consists of our own business (50%) and real estate (50%). This is perhaps the kind of diversification that has made the most millionaires throughout history, and especially in our most recent history (the last decade).
The problem is that every real estate investor has seen the value of their assets fall in recent years as property prices dropped. On the other hand, an investor who had cash and put it into stocks, taking advantage of the rise of the S&P 500, has earned more on their money than the real estate investor. Contrary to what many people think, the growth in the number of millionaires in the US has been due to the appreciation of their investment portfolios, with a large percentage invested in stocks.
See also: The curse of Japanese investors
Property is a more complex world of investment
Besides requiring much more capital, we cannot say whether real estate is more or less profitable than other investments. It depends on the moment, the current market and the country. During the property boom it was without doubt the most profitable option, whereas now I would have my doubts about this kind of investment, especially in Europe and more specifically in Spain, where the biggest real estate agency is the banking sector, which can compete in a way I would venture to call “unfair”.
See also: Ways to invest in real estate
Now, if we look at one of the millionaires we often use as an example, Warren Buffett, his portfolio diversification does not match either of these two, but is rather a mix of both. Buffett’s business does not involve real estate, but it does involve his own business, which is undoubtedly his most profitable investment: Berkshire Hathaway.
In Buffett’s case, his portfolio diversification consists of his own business, stocks and bonds. I don’t know what percentages he uses, since his company is in turn the one that buys the stocks.
For those who are just starting out and plan to follow a financial plan, it is clearly unlikely that they will begin by diversifying into property, so their portfolio needs to include equities if they want good returns. If you are young and want to build a healthy financial future, your diversification should be 80% stocks and 20% fixed income. If you want to take on more risk to get better returns, you should have 100% in equities.
However, since most people’s problem is how hard it is to secure a recurring income given the shortage of jobs, your diversification should probably be 70% in your own business, since you will have to start one, and 30% in equities.
I know, this is all a bit confusing. In the end, everyone has to ask themselves the right investment questions: What return do I want? What options do I have for earning income? How much risk am I willing to take…? Only then can you diversify your capital in a way that suits your needs and profile.
Featured image: Julie Ceccaldi, CC0 1.0, via Wikimedia Commons.
