What Is Diversification & Why Does It Matter?
By Will Paustian, CFP®
Diversification is an investing concept that can improve returns and reduce risk by spreading your funds across several different asset classes (stocks, bonds, real estate, and more). If you’ve ever heard the phrase “Don’t put all your eggs in one basket,” then you’ve heard of diversification. Though it’s a simplified example, it illustrates the same concept as not investing all of your resources in one or two assets. Read on to learn more about the definition of diversification and how it can be used in your portfolio.
One of the primary roles of diversification is to reduce the inherent risk associated with investing in the stock market. This doesn’t just mean diversifying between growth stocks and value stocks, though. In fact, it’s not enough to concentrate your assets in just two positions and call it diversification. True diversification requires incorporating a mix of different types of investments like stocks, bonds, international investments, and real estate.
At JGP Wealth Management, we believe in diversifying across asset classes and within asset classes. For example, we diversify by market capitalization (small-, mid-, and large-cap) and across market sectors. We diversify across short, intermediate, and long-term bonds, treasuries, corporates, and municipal bonds. By improving your exposure to many different asset classes, you can reduce the chances that any single investment will drastically alter the overall performance of your entire portfolio.
This is important if you work for a publicly traded company and own a highly concentrated position in your company’s stock, as many corporate executives do, or if you own your own business and have most of your equity tied up in the company. Both of these scenarios leave you highly exposed to risk; one volatile swing in your company’s stock or a few rough years in your business could leave your portfolio devastated. Utilizing diversification, however, allows you to spread out your assets across many different investments and minimize risk in the process.
Downturns and recessions are expected. In fact, they are normal parts of the economic cycle. But if downturns are anticipated, that also means rebounds are likely. Since its inception in 1926, the average return from the S&P 500 has been 10-11%, which is exactly why it’s important to take a long-term, diversified view on investing. Simply keeping your money in the stock market versus quickly buying and selling can help you improve your returns.
Think of it this way: When the global pandemic happened in 2020, 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. This is a great example of how investments respond differently to economy-wide shifts, which highlights the importance of diversification as a hedge against both short-term and long-term losses.
Because of the unpredictability associated with short-term stock market success, diversification and investing according to when you need the money can help you reach your goal with more confidence when compared to putting all your eggs into one basket.
Finding the Right Mix
Since perfection is notoriously unattainable, finding the right mix of investments can feel like you’re looking for a needle in a haystack. Everyone has their own unique goals, dreams, timelines, and risk capacity—what’s ideal for one may not be ideal for another.
Remember that portfolios can change with time; that’s the beauty of the stock market—you can change your portfolio as your goals evolve.
As we mix and match asset classes and strategies, risk-capacity decisions need to be made no matter the timeline length. By optimizing the way your portfolio is constructed, we can help minimize risk and maximize returns.
Is Your Portfolio Diversified?
No matter where you are in your investment journey, diversification is a key component to consider. If you have questions about your portfolio, or you would like to discuss your overall financial plan, we would love to hear from you. At JGP Wealth Management, we assess your risk tolerance, analyze your current financial situation, and build a portfolio tailored to your needs. To learn more about how we can help, reach out to me at firstname.lastname@example.org or 503-446-6450.
Will Paustian is a financial advisor at JGP Wealth Management, an independent, fee-based financial advisory firm in Portland, Oregon. Since joining the JGP family in 2020, Will has played an integral role in the firm by combining his knowledge of the financial world with a strong and dedicated work ethic in order to help our clients achieve their financial goals. Will is known for his commitment to walking our clients through everything they face in their financial lives, celebrating their victories along the way. He specializes in serving executives and entrepreneurs, specifically in the food and beverage industry and business owners planning to pursue an exit, tailoring his solutions to fit their unique financial challenges and opportunities.Will graduated from the University of Oregon’s Robert D. Clark Honors College with a bachelor’s degree in finance and entrepreneurship, minoring in economics and is a CERTIFIED FINANCIAL PLANNER™ professional. He was awarded the Stamps Leadership Scholarship and served as a student trustee on the University Board of Trustees. He also spent time abroad in the UK studying behavioral economics at the University of Oxford. When not in the office with clients, Will enjoys a wide variety of activities, from hiking and fishing to cycling and traveling. He, along with his family, enjoys the sights and sounds of Oregon, cheering on the Oregon Ducks and the Portland Trailblazers and exploring the unique restaurants and businesses around the Portland area. To learn more about Will, connect with him on LinkedIn.