“Don’t put all your eggs in one basket”
“If you put all your eggs in one basket, guard the basket”
Conversations around diversification often revolve around which groups of stocks or mutual funds to own in what proportions:
- Domestic vs International
- Large Cap vs Small Cap vs Mid Cap
- Stock Funds vs Bond Funds
- Individual stocks or bonds vs mutual funds or ETFs
Being a Senior FI guy, I give this conversation a cranky Harumph!
This is NOT what diversification is really about.
Think of your family unit as a business, YOU INC.
Diversification is about YOU INC. creating multiple independent sources of income. The hope is that all sources will do well, but in case some do not, the goal is that at least some will in any given time period and YOU INC. will prosper as a result.
Examples:
- W-2 income: This is income from your full time and/or any part time jobs
- 1099 Interest income: this is generated when you are the lender, whether it is checking/savings or CDs at banks*, corporate bonds, municipal or US government bonds (or t-bills), or any other type of loan that generates interest for you.
- 1099 Dividend income: Dividends are paid by a corporation that is sharing profit on a per share basis. If you own 100 shares of stock and it pays $2 per year per share, you will make $200 per year in dividends.
- Schedule E Real Estate Rentals: You are the landlord and report income (and expenses) on Schedule E of your tax return
- Schedule E Royalties: not discussed much on FI websites. May devote a separate post on this.
- Schedule C Income: If you have a side hustle or a full time business that you run as a sole proprietorship, this is where you report this income (and related expenses)
- Schedule D Capital Gains: The proceeds of selling stocks or other items of value are reported here. Remember to buy low and sell high! (How to make a small fortune in the stock market? Start with a large one!) Some people have a really good sense of when to buy and when to sell. I don’t count myself amongst them. Mutual fund and ETF gains are reported here as well.
- Sch K-1 (LLC, Partnerships, Joint Ventures, P.A. etc – IRS considers them all the same) – these are all various businesses that file their own partnership return and distribute the income through a Schedule K-1 to each partner. This is called pass-through income, as the K-1 will tell you which lines of your tax return to put the income on.
If you are going to truly diversify your sources of income, consider generating income from many of these buckets.
The Tie Dye family have used all of the methods above. Mrs. Tie Dye has her own business (Sch C). We participate in some partnerships that generate Real Estate and Royalty income. We have our own rental real estate. We get 1099s for credit union interest (they call it dividends just to confuse everyone) and for dividend income from stocks we own. Mr. Tie Dye is still generating W-2 income from a job.
As our mutual funds re-balance their portfolios (sell some stocks and buy others) they generate capital gains which they kindly report to us on a 1099.
I did leave out farm income which reports on other forms. I don’t see many farmers yet in the FI community.
Some of these sources of income have interesting tax advantages over others. Sounds like a future post is needed!
The point here is that YOU INC. can diversify by generating as many forms and sources of income as you want. Do not think of diversification only as a question of which stocks or mutual funds to invest in. The picture is much larger.
* I doubt most people think of their checking/savings/CD accounts as loans to banks or credit unions. That is exactly what they are. Banks pay you wholesale (lower) rates for this money and lend it out to borrowers at retail (higher) rates, making the difference on the arbitrage as one source of profit. If you want to borrow money at lower rates and lend it at higher rates, become a bank! This would be yet another source of diversification.