We’ve all done it. Someone recites an old nugget of wisdom and we grin and marvel at those wise souls that trod the ground long before us. They’ve been there and done that. "Don’t put all your eggs in one basket" is a favorite. We all know that peaks in the commodity production business are short-lived and prices will level out. So how can you maximize your bottom line when a large chunk of your resources has stalled?
Mixing it up. One way to maximize your bottom line and help weather the low points in the cycles is by diversifying. Diversification is a technique that is geared toward maximizing return by allocating your resources in different areas that, ideally, would react differently to the same event. It might not guarantee you won’t have a loss, but it will minimize your farming business risk.
There are numerous ways for farmers to diversify their business—from using different seed genetics or crop rotations to investing in an ethanol plant or adding livestock to the mix. Even pursuing an off-farm venture can make sense.
If you’re looking at alternative investments, either on or off the farm, it is important to consider the financial benefits. For example, assume you have $100,000 to invest in a business venture that will earn you a 7% return for 10 years. Essentially, you will be doubling your money. This return on investment follows the "rule of 72" used by many financial planners: Take 72 and divide it by the percentage of return. The result is the number of years it will take you to double your money (72 ÷ 7 = 10).
Let’s take the same $100,000 and invest it five ways. The first $20,000 is invested in a business that earns a 20% return per year for 10 years. (That might seem impossible, but one of my clients has had an average return on equity of 22.87% for 35 years.) A second $20,000 is invested in a business that earns 15% per year. A third $20,000 returns 7%. A fourth $20,000 is invested in a venture that earns nothing for 10 years, and the final $20,000 is invested in a business that actually loses that entire investment. Despite all of the varying returns on investments, the $100,000 investment will be worth almost $265,000 in 10 years.
There are lessons to be learned from these two investment strategies:
- Diversification pays—and it is more important to be diversified during periods of rapid change.
- Don’t beat yourself up if you have a couple of losing investments through the years. A couple of winners will get you further ahead.
- Adversity actually adds to your odds of being successful if you learn from it. J. Barry Griswell and Bob Jennings point this out in their book, The Adversity Paradox. Obstacles and setbacks are an inevitable part of life, especially in today’s harsh and volatile economy. The secret is to not stall and stumble but use those experiences to move forward.
A word of caution when considering diversification: Don’t get involved in a business that you don’t understand. The idea is to spread your resources to reduce your risk, but it’s not a no-brainer. You’ve got to know the downside of each of those money flows so you can manage them.
- Early Spring 2012