Risk & Diversification

Terry Herr, CFP®, CLU

Every day in our office we use a lot of financial jargon.  We appreciate when a client stops us to ask what something means.  Often, we get questions about risk management and diversification. What does it mean? What is the goal of it?  

Simply put, diversification is one way we help manage risks in an investment portfolio.  For purposes of this article risk is defined by the ups and downs (the rollercoaster ride) of your investments.  .

Diversification

The saying “don’t put all your eggs in one basket” sums it up quite well.  If you drop the basket, you risk breaking all of the eggs. Over time, certain investment asset classes may perform better, or worse, than others. If your assets are mostly held in one kind of investment, or highly concentrated in a single stock or investment sector, you could find yourself under a bit of pressure if that asset class experiences a decline. 

The roll of diversification (asset allocation) is to help lower investment risk.  The idea is that if you are diversified, not all of your investments will move up and down together or to the same degree. Some may go up, while others are going down, which helps reduce fluctuations in value of the whole portfolio of investments. Diversification is designed to make the rollercoaster ride a bit smoother. It does not eliminate the risk of loss and it often does not necessarily result in higher short or long-term returns.  

When we ask you questions about your goals, time horizon, and tolerance for risk, we are getting a better idea of what asset classes may be appropriate for your situation. More importantly, having a handle on your tolerance for loss and your need for returns you avoid making the mistake in selling when returns are negative. Diversification is all about helping you stay the course and remain disciplined in the march towards your financial goals.

Determining an Appropriate Mix

Appropriate asset allocation is determined by each individual's situation. Here are three broad factors to consider:

Time

Investors with longer timeframes may be comfortable with investments that offer higher potential returns but also carry a higher risk. A longer timeframe may allow individuals to ride out the market’s ups and downs. An investor with a shorter timeframe may need to consider market volatility when evaluating various investment choices.

Goals

They come in all shapes and sizes, and some are long-term, while others have a shorter time horizon. Knowing your investing goals can help you keep on target. 

Risk Tolerance

An investor with higher risk tolerance may be more willing to accept greater market volatility in the pursuit of potential returns. An investor with a lower risk tolerance may be willing to forgo some potential return in favor of investments that attempt to limit price swings.

Have Your Investing Priorities Changed?

Asset allocation is a critical building block of investment portfolio creation.  If your investment priorities have changed, then it may be time to revisit your investment allocation and the level of risk you are taking.  Having a strong knowledge of the concept may help you when considering which investments are appropriate for your long-term strategy.

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