Passive income business risk and diversification
It is extremely important to employ diversification in your passive income business ideas to ensure that you minimise your portfolio risk. Diversification is defined as distributing your investments into unrelated asset classes in order to reduce the risk of your investment portfolio and increase returns. This definition has a number of key principles that we will need to dissect. So in order to understand what diversification looks like, let’s examine the portfolios of 3 fictitious individuals that all live in the same neighbourhood; Adam, Ben and Cindy.
Adam has diversified his real estate portfolio by purchasing different types of property in the city that he lives in. Adam manages 10 investment properties that include; units, houses, commercial property and townhouses. Adam was happy with his investments and their rental returns until there was a downturn in his city due to the end of the mining boom. Adam is now finding it difficult to rent out some of his properties and has had to lower rents in order to attract tenants which is impacting negatively on Adam’s cash flow situation due to his commitments to his mortgage repayments.
Ben has diversified his share portfolio by choosing to divide his total portfolio into four equal parts with 3 different managed funds managing three quarters of his portfolio and Ben chooses to invest one quarter of his total portfolio in blue chip stocks. Ben has seen consistent returns on his total portfolio using this diversification strategy, however the global financial crisis impacted negatively on the whole investment portfolio and Ben now feels that his retirement plans will need to be put on hold until his investments are propped back up.
Cindy has diversified her time and her investments into four different sources of income. Cindy has two investment properties that generate rental returns, money invested in blue chip shares that generate income through dividends, income from advertising and sales on Cindy’s blog, and income from an eBook that Cindy wrote years ago. The downturn due to the mining boom and the global financial crisis had an impact on Cindy’s investments but nowhere near to the extent of Adam and Ben because Cindy’s investments were truly diversified.
To delve into the concepts of risk and diversification a little more, let’s talk about market risk and specific risk.
Market Risk and Specific Risk
Market risk is all of the inherent risks associated with that market such as economic influences. For example, Adam’s portfolio is at the whim of all the market risks associated with real estate such as interest rates, and housing supply and demand. Similarly Ben’s portfolio is at the whim of market risks associated with share investment such as trade policy, commodity prices and stock market bubbles.
Specific risks are those that impact on a specific set of investments. For example if the share price of one Bank was performing poorly then it is highly likely that all the share prices of the banks are performing poorly. This could be as the result of a government banking policy change or inquiry.
So the key to spreading your risk around is to diversifying your passive income businesses and investments into multiple asset classes or income generating vehicles that won’t be adversely affected by one particular market or specific risk. So the more diversification the better right? This brings us to the concept of over diversification.
An over diversified portfolio will mean that there may no longer be a risk of any great losses, however there will be a reduced possibility of any great gains. To give an example, say that you had two choices;
Choice A: You could invest equal parts of your total capital in 100 different companies, or
Choice B: You had the option to invest equal parts of your capital in 10 different companies.
Which would be the best way to proceed?
You would have a lower risk investing in Choice A, however you would have a limited chance of gaining greater returns as the amount invested in each company was a lot smaller than if you had invested your capital as outlined in Choice B.
So what is the Goldilock’s zone for diversification in passive income investments and businesses, such that you are not under or over diversifying? This really depends to what degree each investment is passive and how much time you have to manage your investments, however as a general rule, 5 different income vehicles is plenty for one person to manage. If you have plans for world domination, then you will need to recruit a team (employees) and your team will obviously be able to manage more passive income investments on your behalf.
The Sleep Factor for your passive income business
The next thing to consider when thinking about the level of risk you are comfortable is simply called the sleep factor! This means that you should only invest your time and capital into investments that will allow you to sleep at night. Or another way to think about this is to only invest a small amount of your total capital in high risk investments. I could start talking about all the benefits of uninterrupted sleep, but I am sure I would be just preaching to the choir! If you are unsure of what your tolerance for risk might be, and what your sleep factor is, jump onto Google and look for ‘determine the type of investor you may be’ and assess yourself. There is also a large amount of material on this topic and if you would like to delve into this concept some more, organise and appointment with a financial planner.
When talking about risk, there are a few golden rules.
- Protect your capital (the amount you originally invested). It is not how much money you make on any of your investments that makes you rich, it is how much you don’t lose over time
- Don’t under or over diversify. The more investments that you manage the more work that you will need to do to manage your risk level
- Never invest all your capital into one asset class
- The higher the return from your investments that you desire, the more knowledge, experience and time you will require to devote to achieving your goals
So now you have an understanding of what diversification is and your tolerance for risk (sleep factor). The next thing to understand is that not all investments are equal in their risk.
Not all passive income businesses are created equal
This sometimes referred to as the risk versus reward ratio of an investment and as the saying goes, the higher the risk the higher the reward (and the higher the potential for loss). When researching potential passive income businesses and investments it is important to determine what the inherent risks are to your time, effort and capital might be. The determination of risk for all your passive income activities should be the cornerstone of your passive income financial freedom business plan!
Return of Capital in your passive income business
Return of Capital is another aspect to risk management that is not often fully understood, employed or discussed. The textbook definition refers to principal payments back to capital owners that exceed the growth of a business or investment (thanks Wikipedia). To put this definition into an example, say that you buy 100 shares of company XYZ at $1 per share such that you now own $100 worth of shares. You hold your company XYZ shares for 5 years and the share price increases to $2 per share. You decide to sell half of your shares (50 shares) of company XYZ netting a profit of $100. How much risk to the loss of your capital do your remaining 50 shares pose to your portfolio? The answer is none, as you recouped your initial investment when you sold half of your shares. So you can sleep a little easier knowing that your remaining 50 shares are pure profit generating vehicles.
More passive income business ideas
If you are interested in learning more about passive income ideas, reducing expenditure and passive income business diversification then have a look at this site www.passiveresidualincomefreedom.com