The Power of Income Stream Diversification
“Probability is not a mere computation of odds on the dice or more complicated variants; it is the acceptance of the lack of certainty in our knowledge and the development of methods for dealing with our ignorance.” - Nassim Nicholas Taleb
Achieving financial stability and security hinges significantly on understanding the concept of diversification, both within investment portfolios and in generating income. Just as diversifying investments helps mitigate risks, diversifying income streams can provide a safeguard against the uncertainties of relying on a single source.
Diversification can mean allocating resources across a variety of stocks to counterbalance the effect of any individual stock's unpredictability. Similarly, under the Income OS framework, spreading out income sources ensures that an individual is not overly reliant on one primary income source.
Let's illustrate the benefits of diversification:
Given each stock's standard deviation (a measure of risk and volatility):
Stock A: 15%
Stock B: 20%
Stock C: 25%
The risk dynamics change as we transition between portfolios:
Single Stock:
Investment in Stock A: 100%
Portfolio Standard Deviation: 15%
Here, the portfolio's risk is solely determined by Stock A's volatility. This is just laziness and where most individuals end up with their income portfolio.
Portfolio of Two Stocks:
Investment in Stock A: 50%
Investment in Stock B: 50%
Portfolio Standard Deviation: 13.5%
With the addition of Stock B, overall portfolio risk decreases, even though Stock B itself is riskier than Stock A. This showcases the principle that combining assets can lead to a risk profile that is different from the individual risks of those assets.
Portfolio of Three Stocks:
Investment in Stock A: 33.33%
Investment in Stock B: 33.33%
Investment in Stock C: 33.33%
Portfolio Standard Deviation: 12%
Incorporating an even riskier Stock C further reduces the overall portfolio risk. This underlines the intriguing aspect of diversification: by adding more seemingly risky assets, the overall risk of the portfolio can decrease, providing both a safety net and the potential for greater upside.
By strategically diversifying and potentially taking on seemingly riskier income streams, you can reduce overall vulnerability while opening up possibilities for increased gains. This approach highlights the principle that diversification, when done right, can lead to both protection and growth.