Perhaps you’ve heard the idiom ‘don’t put all your eggs in one basket‘?
This phrase pretty much sums up the concept of ‘diversification’.
‘Diversification‘ is a risk management strategy, usually applied to investment portfolios. Investing all of your money in Coca-Cola shares would be an example of poor diversification, while having a portfolio that consists of some investment property, 15-20 different companies’ shares across a variety of different sectors, a bit in cash, and some bonds and international stocks would be considered much more diversified.
But have you though about the concept of ‘diversification’ in relation to your income?
Remember our couple Abby and Bobby who run a business? Even though they both work, earning $50k a year each, their jobs are at the same place. If the business goes under, so do they. Everything Abby and Bobby have is invested in their business, and it is their only source of income. In good years, they also take home an additional $30k or more in profits from the business.
On the other hand, Carrie and Derrie have much more diversified income. Carrie earns $45k a year working for Abby and Bobby, and around $1k selling handprinted t-shirts online. Derrie works part-time earning $25k a year. They have $50k invested in shares and earn $2k a year in dividends.
Who is better off?
On the face of it, Abby and Bobby’s income, at double Carrie and Derrie’s seems to be the easy answer. But if A&B Fashion Store fails, then Abby and Bobby are down $132,000, giving them $0 income until they can find another job, while Carrie and Derrie would only lose Carrie’s wage of $45,000, leaving them with $21,000 – certainly it will be tougher, but definitely possible for them to keep afloat, provided they have been sensible with any debt. If need be, they can sell their shares, swapping their long-term $2,000 annual income for a once-off boost from $21,000 to $46,000 in order to tide them over until Carrie can find another job or make more money from T-shirts. Likewise, if Derrie is fired, they will still have $41,000. If on top of that people stop buying Carrie’s T-shirts, they will still have $37,000 and if then, on top of that, all of their shares stop paying dividends, Carrie and Derrie will still have $35,000 a year to live on.
In other words, Carrie and Derrin would have to have an extraordinary run of bad luck in order for them to lose all of their income.
Another way of visualising income diversification is to consider your income streams as a web. Abby and Bobby’s web has only one strand, and if it breaks, currently, their entire income breaks. Carrie and Derrie’s web, however, has multiple strands, meaning that just like a spiders’ web instead of a tightrope thread, it can withstand more breaks.
Of course, it doesn’t make sense for Abby and Bobby to sell up their profitable business and quit their well-paying jobs in order to become employees of someone else and take on some part time work like Carrie and Derrie. There are other things they can do – take out business and/or income protection insurances, for example. Build an emergency fund of 3-12 months’ worth of their expenses. Redirect some of the income the invest back into the business into other investments, or save some of their more substantial income to build a portfolio, like Carrie and Derrie have done.
How diversified is your income?
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Today’s featured image is the eggs in our wonderful Fijian home-away-from-home!