Preserve or Create Wealth - A Balancing Act

Everyone should include diversification and concentration of investments in one's wealth building strategies. Diversification preserves wealth, concentration creates wealth. The right balance will depend on one's risk tolerance.

Diversification

Modern Portfolio Theory shows that one can generate excellent returns that exceed inflation through diversification. Since 1926, the stock market (e.g. a diversified stock portfolio) has averaged a 10% annual return. Over a twenty year period, one's investment would grow 6.7 times at 10% annual returns. While any one year may be negative, there have been very few extended periods of decline in the U.S. stock market. First Investor notes that from 1926 to 2005, there the market was up in 57 out of 80 years. However during rolling 10 year periods, the large caps were up in 69 out of 71 periods and in all 15 and 20 year rolling periods.

Concentration

According to Yahoo! Finance, 80% of people with over $5 million in net worth did it via their own business or working for a small company that grew quickly. They earned the majority of their net worth through focus and commitment to one company or business. 10% inherited their wealth. I guess the last 10% do it by working and saving or winning the lottery :-)

Similarly, the average person investing in an index fund won't make $5 million. Getting excess returns on stocks requires concentration in one or two stocks. While a diversified portfolio will average 10% returns, single stocks can return over 30% per year. For example, this May, 2007 Motley Fool article shows $1000 invested in Microsoft in 1986 was worth $386,250 and $1000 invested in Dell in 1988 was worth $246,700. Over 20 years, this was a 32.8% and 33.6% annual return for Microsoft and Dell, respectively.

Remember Risk

While there are many examples of concentration creating great wealth, concentration can also significantly reduce wealth. Investing in a single stock, starting a business, working for a small growing company is relatively high risk and will fail more often that returning great wealth. There tends to be a survival bias in the reporting of results, i.e. successes are highlighted more often than failures.

My personal preference is to preserve wealth via diversification for the majority of my financial assets and to risk only a small part (e.g. less than 10%) on creating wealth via concentration. However, due to the majority of my retirement fund being invested in my company's stock, I am currently closer to 40% concentration at this time. Since our company stock has done well in the past decade, this concentration has helped create wealth for me. However, over time I plan to transition the concentration in my company's stock to a more diversified portfolio.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

Photo Credit: morgueFile.com, Jim Mason

This is not financial or investing advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC