Defending your FIRE fortress – Part 3 – Diversification

Diversification

It’s a shame this is the last in the FIRE fortress series we really enjoyed working with this knight, he reminds us of the Monty Python Holy Grail film. We watched it again a couple of days ago, the humor never get’s old.

Anyway back to the point, diversification. We already mentioned back in the Dividend investing in a rising rate environment post how it is difficult to diversify when investing in dividend stocks since there are less industry options. We therefore try to restrict ourselves to a $1000 investment in each similar industry such that any losses are limited. Just because one company in a particular industry cuts it’s dividend though doesn’t necessarily mean they all will, case in point Conoco-Phillips during the OPEC-led drop in oil prices. Just because they cut the dividend didn’t mean BP, Exxon or Shell had to, they are all in the same industry but the former has heavy exposure to drilling with less refining focus since the Phillips66 spin off. Whereas the others pivoted to their refining activities and acquired LNG companies to keep the dividends going, Conoco had no option but to cut when it’s main source of revenue lost value making it no longer cost efficient to drill. On the face of it these were all oil companies per se but the difference is that their respective managements had different tools to react to the same industry shakeups and downturns. The lesson for us being to make sure that even though the industries we are investing in are similar and non-diverse, we just need to ensure each company has diversified income streams of their own to fall back on in downturns.

By restricting our exposure to any one company in this way we shield ourselves from one dividend cut taking out an entire passive income stream, instead we might see a reduction but we can still bounce back by selling and finding a new home for our $1000, which might have now dropped in value by a couple of hundred dollars on the cut news but at least the drop isn’t in the thousands like it would be if we had heavy exposure.

Even if we are using dividends as part of our income stream, we don’t want to start labeling ourselves as dividend investors and falling in love with it as our go to strategy. On the contrary, we need to look at every other investment vehicle which is anything but dividend investing, which bears absolutely no relation to a single dividend stock. Per our post about investing in CDs in a rising rate environment it can be seen that the action of investing in CDs has no similarity whatsoever to our dividend investing so can be used as a diversified alternative. We can further diversify in this instance by laddering them with different banks so that in the event of one bank failure per 2008 we don’t have all our eggs in that one basket. The same applies for bonds, these may act similarly to CD’s but can be classed as diversification due to the issuer being the government, diversified corporations or state municipalities.

When we look at income from rental properties it also benefits us to keep a diversification mindset, we might find an absolute bargain of a property with an excellent Return on Investment (ROI) in a particular area which suits us really well because maybe it is next to a large military base for example, a hospital or a large corporation. In this situation we might also see another low priced property in the same area and think that we are getting a two for one bargain that is too good to miss, doubling up our income stream. The problem then is we place all our eggs in the one basket, or in this case we rely to heavily on the success of that business, should that source of our tenants income close down then our two for one deal can wipe out two or more income streams instead of one. This is also the unfortunate downside to owning multiple apartments in one building, it removes the diversification aspect to the income. The diversified course of action is to buy properties where our tenants are being paid by completely contrasting industries, ideally in different cities or even countries with different sources of revenue and currency, even if it now makes us reliant on property management companies.

The latter subject of currency diversification never really get’s a mention because generally it only really affects travelers and expats. One of our main issues at this time that we are addressing is our overexposure to the US dollar. In the event that the dollar takes a nosedive for any reason then we have less of it to convert into the currency of whichever country we are visiting at that time, in fact the drop in value can risk negating or even reversing any dividend growth increases, effectively giving us a pay cut. In order to address this we are currently trying to purchase UK buy-to-let income property while it is heading into a down-cycle due to changes in the tax treatment of buy to let mortgages. We are doing this so that if there is an issue with the value of the US dollar then we can just allow it to accumulate and earn interest in the bank while we use the British Pound for our exchange income until the dollar bounces back. This way we can effectively pick and choose the optimal currency rate for our conversion depending on the particular country we are visiting. Additional to the pound it may be worth exploring Euro-based opportunities beyond this purchase so that we then have three diversified currency options to choose from.

From here forward there are a multitude of other diverse passive income opportunities if we spend enough time exploring them, all of them unrelated to the income sources we have previously discussed. If we travel a lot then we could upload our photographs to any of the stock image websites in order to try to receive royalty income, or if we write an e-book we might start a diversified income stream receiving royalty payments from that. A lot of people also now receive advertising revenue from writing a blog, this avenue has great earning potential as long as again it is not the sole source of income as traffic can fluctuate considerably, it is very much reliant on the content remaining relevant or popular with the readership and that can never be a given.

In conclusion, diversification is critical to defending our FIRE fortress so that if we lose an income stream for any reason then we have a wide selection of diversified backups either temporary or permanent that we can choose from to keep us going without suffering too much hardship or forcing us back into regular full time employment. The more diverse and independent the better..

We are long BP, Exxon, Shell.

Thanks for reading,

DN

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