This is Part 8 of my nine-part series connecting financial frameworks with personal growth.

1.      Finance as a Framework

2.      Assets = Liabilities + Equity: What You Own Comes with Strings Attached

3.      Assets = Liabilities + Equity 2: What You Have vs. What You Can Use

4.      Time Value of Money 1: The Power of Compound Interest

5.      Time Value of Money 2: Why Humans Use Bad Discount Rates

6.      Risk and Return 1: No Risk, No Return

7.      Risk and Return 2: Why Humans Are Bad at Calculated Risks

8.      Risk and Return 3: Diversification, Finance’s Only Free Lunch

9.      Conclusion: The Emotional Balance Sheet

Last week, we discussed how human beings have a difficult time differentiating between perceived risk and true danger. This week, we discuss the financial principle of diversification and how it maps to our personal lives.

Diversification in Finance

“There’s no such thing as a free lunch” is a favorite saying among economists. It means that anything that offers a benefit carries some cost as well, even if the cost isn’t obvious.

However, in finance, there is one place we can get a free lunch. That is diversification.

Diversification refers to a method of building an investment portfolio where combining two assets—each with its own return and risk profile—results in a portfolio where the total return is the weighted average of the two assets, but the total risk of the portfolio is less than the weighted average of the two assets. In other words, by owning a diversified portfolio, an investor can enjoy increased return at the same level of risk as a single asset, or can enjoy the same level of return as a single asset but with an overall reduced risk profile. Diversification breaks the relationship between return and risk in the favor of the investor.

More concretely, diversification is insurance against things going wrong. The adage “don’t put all your eggs in one basket” summarizes the idea. If I invest all my money in a tech stock and that company’s software goes obsolete, I am screwed. Whereas if I invested my money in a mix of tech, energy and healthcare stocks, I’m partially protected against a blowup in any one of those sectors. Diversification is a tool to mitigate downside risk.

Diversification: Skills and Self-Esteem

In our personal lives, where do we face downside risk that we might mitigate through diversification? What part of our lives do we want to diversify? Two aspects stand out to me: skills and self-esteem.

Becoming a Polymath

A polymath is “an individual whose knowledge spans many different subjects, known to draw on complex bodies of knowledge to solve specific problems.” In Renaissance times, being a polymath was considered virtuous (and still is to some extent today) but I view it as a risk mitigation strategy as much as an expression of personal values.

Society and the economy are constantly changing, and skills can grow obsolete. Just like stock investors can’t predict market crashes, we can’t predict which of our skills will be useful in five years and which will become obsolete. If I specialize in being a great website copywriter, and generative AI becomes really good at that, then the market value of my core skill goes to zero.

By contrast, I can accept that some subset of my skills will naturally grow obsolete with time and I can instead invest in building up a diversified set of skills. In addition to copywriting, I could learn creative writing, technical writing, and generative AI prompt engineering. I could also learn unrelated but universally valuable skills like no-code software engineering, sales, project management, et cetera.

Furthermore, nothing stops me from developing expertise in completely different fields. I could learn some area of hard science, theology, music, or whatever. Sometimes the most valuable “returns” come from mixing knowledge from two very disparate areas, like say, emotions and finance. It also works as a risk mitigation strategy, because if my investing career doesn’t work out, I can just go be a life coach.

Diversification of Self-Esteem

On a more deeply personal level, I think diversification matters a lot for our sense of self-worth.

I think of our sense of self-worth like a stool. Each leg of the stool is a pillar of self-esteem. A stool with one leg is easily knocked over; a stool with three, four, or five legs, much more stable.

Growing up, “being smart” was my only pillar of self-esteem. As a result, I was insecure in many social interactions, getting into arguments and putting people down in order to protect my single source of self-esteem. As I grew out of my teens and early twenties, I gradually started to take pride in other qualities, like being loyal, a cool head in a crisis, a good listener, et cetera. I notice that I am much more tolerant to being criticized or challenged than I used to be, because the stakes feel like they are a lot lower. Even if I make a mistake or say something stupid, I don’t feel myself becoming defensive.

This is also a risk-mitigation strategy. Just like we can’t predict which stock in our portfolio is going to be exposed as a fraud, we can’t predict the random events in life that will challenge our self-esteem. For example, I can’t predict if I will be diagnosed with a degenerative spinal condition or not. If I am diagnosed, and my identity rests on being a great athlete, I am in real trouble. If my self-worth stool has four additional legs, like being a great father, being an expert in a technical field, being a volunteer for a cause important to me, and a consistent spiritual practice, I’m much more likely to thrive in the face of that negative health event.

Other areas

There might be other areas of our life where diversification makes sense as a risk mitigation strategy. There might be diversification benefits to diet and exercise, like not excessively stressing some digestive function or physical area of the body. There are probably some diversification benefits to travel, hobbies and life experience. There are certainly diversification benefits to networks and friend relationships, since we can’t predict where we might have a falling out with someone. (Investing in a diversified portfolio of romantic partners may create a different sort of risk, however.)

Is Non-Financial Diversification a Free Lunch?

No, it isn’t, and this is where the analogy breaks down.

Diversification is still inherently good as a risk-mitigation strategy, but unlike adding a new stock to a portfolio of investments, diversification in our personal life carries significant cost.

Learning a new skill takes time, and requires continual investment. But even though there is a cost, the potential for increased returns and mitigated risk may be in many cases worth it. My sense is that the threshold for achieving a diversified portfolio in our personal life is much lower than in investing. In traditional finance, we more or less max out the diversification benefit of a stock portfolio when we get to about 20 stocks. By contrast, we certainly do not need 20 sources of pride and self-esteem to become a stable and resilient person—we probably only need three. Becoming adaptable to changes in the economy might require adding only one new skill to whatever I already know.

Even with the cost, diversification is a strategy worth pursuing. Better to pay the cost up front than to get wiped out by your personal life’s version of a stock market crash.

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Next week, we conclude the series with a summary of the ideas we’ve discussed over the past two months with the “emotional balance sheet.”

Exercise

Journal on the following or discuss with a friend

1)      Concentration Assessment

Where in my life do I have “all my eggs in one basket?”

Do I have a very limited set of friends? Am I overly reliant on one skill that is at risk of becoming obsolete?

In terms of self-worth, what do I take pride in? Do I notice myself becoming angry and defensive when others challenge that source of pride? If so, I may need to add more legs to my self-worth stool.

2)      Choice

Trying to do too many things at once is usually a recipe for failure. Unlike stock market diversification, personal diversification carries significant cost, and we must be judicious about accepting new costs into our already-stressful lives.

Of the areas in my life that I am not diversified, where does something going wrong carry the greatest danger? Where am I most scared of a negative risk event?

Deliberately choose one area of your life to begin diversifying. Don’t worry, you can always diversify in other areas later. But one step at a time.

3)      Action

What is the smallest action I can take to diversify that area of my personal life?

Can I sign up for a skills or educational course? Can I try out a new hobby where I might make new friends? Can I commit to a gratitude or other inner work practice that can help me feel more pride and self-worth in who I already am?