Every financial planning firm will want its clients to have diverse portfolios that avoid unnecessary exposure. However, without a strong understanding of the complexities of the market, there are scenarios where trying to deal with one could create trouble on the other front. Let's look at what both concepts are, why there can be problems, and how a financial planning agency might try to help you deal with them.
The basic idea behind diversification is that no section of the economic world should suffer a catastrophic downturn at the same time. For example, bonds often offer a safe harbor when stocks are down because stocks frequently drop when interest rates shoot up and free money in the market disappears. Consequently, having some investments in both can reduce the odds that your entire financial position will collapse.
Diversification also offers upside. People like exposure to stocks, for example, because they want the opportunity to try to find the next company like Amazon that could rocket higher in value. Similarly, investments like real estate allow buyers to benefit from long-term positive trends.
Every financial decision you make creates exposure to some potential problems. If you decide to sit on cash in a checking account, for example, the purchasing power of that cash will almost certainly decline over the years as inflation eats it up. Stocks have exposure to recessions and other major economic shocks. There are no free lunches, no matter how great the financial planning company handling your situation might be.
How Diversification Can Collide With Exposure
Different assets can create similar exposure profiles. The classic example is that bonds and real estate both have exposure to interest rate changes. Even if the relationship seems to be inversely proportional, volatility on conflicting assets doesn't always cancel out. For example, a real estate market could crash before interest rates rise enough to allow bonds to be healthy hedges.
Whenever you buy any asset, you want to think about how it affects your portfolio's diversity and exposure. If an acquisition has similar exposure to something else you own, it doesn't really provide appropriate diversification.
Rebalancing and Hedging
Oftentimes, the solution to the problem is to rebalance your portfolio. This usually means unloading some assets that have similar exposure issues.
Hedging is also a possibility. Typically, this involves investing in things that rise quickly when other asset classes collapse. For example, precious metals often outperform when the stock market crashes or the dollar weakens.
Contact a financial planning firm to learn more.