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The Real Benefits of Diversification

10 Sep

By: Colleen Weber

Investment / News and Updates

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By Colleen Weber, CFP®, CPA

Thomas Jefferson said, “With great risk comes great reward.” But certainly there needs to be wisdom in recognizing how much risk is too much risk—especially when it comes to your investment portfolio. This is where diversification comes into play. 

Diversification can help you offset risk and reach your goals with an added level of confidence. Even if you already have a good understanding of diversification, it’s wise to review its importance and some examples to gain more clarity.

Minimize Risk

One primary role of diversification is to minimize risk in the stock market. This doesn’t just mean diversifying between growth stocks and value stocks. True diversification requires incorporating a mix of different types of investments—think stocks, bonds, CDs, cash, retirement accounts, etc.

There are varying factors that govern the amount of risk you’re open to; one of them is timing. If you are banking on your money being there for you on a certain date, you may choose to invest in lower-risk options like bonds, CDs, and stocks with a history of low volatility.

While your overall returns may not reach the potential had you chosen to take on more risk, you’ll have peace of mind in knowing your money will still be working for you while invested. Saving for college is a prime example where you may have a very specific date in mind of when you or a child will start college. 

If your funds deplete due to poor stock market performance, you may have to take out student loans to pay for your education. Due to the interest rates associated with this debt, you’ll likely choose to invest more conservatively.

As you mix and match asset classes and strategies, risk tolerance decisions need to be made no matter how long your timeline. While aggressive growth stocks have the potential to take off, they present a greater potential loss, especially in the short run. Investing in long-standing, vertically integrated companies provides stability.

Increase Your Potential for Added Gains

Since its inception in 1926, the average return from the S&P 500 has been 10-11%. Learning a bit of stock market history often puts many at ease when deciding to move money from a savings account into the stock market. (1)

Downturns and recessions are certain realities during one’s lifetime, but it’s the same reason many wealth managers suggest taking a long-term view on investing. Simply keeping your money in the stock market versus quickly buying and selling is a risk mitigation strategy of its own.

These downturns also pose new opportunities. For example, take our current global pandemic: 2020 created a unique window of opportunity. Certain high-growth investments performed exceptionally well as the economy reacted to COVID-19, while the brief drop in the market made some value investments available at deeply discounted prices. 2020 provides an example of how investments respond differently to economy-wide shifts, which underscores the importance of diversification as a hedge against long-term and short-term losses.

Because of the unpredictability associated with long-term stock market success, diversification can help you reach your goal with more confidence when compared to putting all your eggs into one basket. 

The Perfect Mix

As everyone has their own goals, dreams, timelines, and risk tolerances, “perfect mix” can be a loaded term. A portfolio that works for one may not work for another. If proposed portfolio options make you break out in a sweat, a more conservative mix may be a better fit. And keep in mind that these feelings can change with time; that’s the beauty of the stock market—you can change your portfolio as your goals evolve. 

When it comes to investment decisions, it’s best to meet with a financial advisor who can learn about your unique circumstances and tailor their advice to your specific financial goals. To partner with an experienced professional who has your best interests in mind, book a free introductory meeting online or call (952) 470-0750. I look forward to hearing from you soon! 

About Colleen

Colleen Weber is a fee-only financial advisor, CERTIFIED FINANCIAL PLANNER™ professional, and CPA with more than 15 years of financial planning experience. Providing comprehensive financial planning and wealth management, she specializes in serving clients nearing retirement, retirees, busy professionals, and women. She is passionate about developing financial plans that save clients on taxes and investment strategies that help them pursue their goals. Learn more about Colleen by connecting with her on LinkedIn or booking a complimentary phone call meeting.

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(1) https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp