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Wealth column: Why portfolio diversification is still important

If you're a frequent consumer of financial media, you likely understand the benefits of having a diversified portfolio. Even with all the coverage, though, there still is some fundamental confusion about the topic.

Bruce Helmer and Peg Webb, financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on KLKS 100.1 FM on Sunday mornings.
Bruce Helmer and Peg Webb, financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on KLKS 100.1 FM on Sunday mornings.

If you're a frequent consumer of financial media, you likely understand the benefits of having a diversified portfolio. Even with all the coverage, though, there still is some fundamental confusion about the topic.

To help clarify the benefits and purpose of being diversified, we're tackling three of the most common misunderstandings about portfolio diversification.

Diversification doesn't totally protect you from any and all risk.

Risk is sometimes thought of as a single entity, but there are actually two primary elements that comprise total risk when it comes to financial instruments: unsystemic and systemic risk. Unsystemic risk is what you can mitigate through diversification by investing in lots of different companies and asset classes. It's based on the idea that some companies and asset classes will sputter while others thrive.

Systemic risk is the risk of investing in the markets. There will be short- and long-term ups and downs that are practically unavoidable no matter how diversified you are. If there's a global recession, for example, diversification will only help you so much. We think the best way to keep afloat during those times is to have a smart financial plan that has you divide your savings into short-, mid- and long-term money, so that you don't have to sell assets at a loss to fund your day-to- day lifestyle.

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Diversification isn't limited to asset classes.

The most common way many investors think about diversification is by asset class. This method of limiting unsystemic risk is common, but it's not the only way to diversify your portfolio.

For example, let's assume that in 2006 an investor owned some stock in Lehman Brothers and owned some corporate Lehman Brothers bonds. The investor assumed he was diversified since he owned stocks and bonds.

But when Lehman Brothers went bankrupt, it suddenly became obvious that he wasn't as diversified as he could have been. Owning stocks and bonds in the same company meant that he was exposed to a significant amount of company risk, and he paid dearly for that oversight.

Diversification goes beyond company risk, too.

The underlying risk of an investment may be a particular company, such as Lehman Brothers, but it could also be inflation, interest rates or a fund manager's skill. These kinds of "hidden" correlations are sometimes difficult to spot, but all are critical when constructing a diversified portfolio. If you haven't assessed your fundamental risk exposure, be sure to ask your advisor if they've considered the risk factors at play in your portfolio.

The purpose of diversification is not to make a bulletproof portfolio; because of systemic market risk, that's essentially impossible. But proper diversification that goes beyond asset classes can help with unsystemic risk, and we believe it's likely your best investment strategy option. It can potentially help insulate you from downside volatility and it can help you participate in upswings-and those two objectives combined may not only help boost your risk-adjusted rate of return, but may also reduce financial-related stress overall.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

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