The Foundational Investor

Building a Financial Future: Investing for Your Goals

In the first installment of The Foundational Investor Blog, we discussed avoiding bad debt, the benefits of investing over the long term, and the advantages of doing so in different tax-advantaged accounts, such as a 401(k) or Roth IRA.

In the second part of this two-part series, we discuss three investment concepts every investor may want to embrace:
1. The importance of diversification
2. The dangers of market timing and stock picking
3. The benefits of investing according to a plan that fits your personal goals

Get Diversified

Stock market swings can test even the strongest-willed investor in the short term. But over the long term, the market has historically shown a remarkable ability to smooth out performance and head upward. Holding a diversified portfolio of many different types of investments helps weather short-term bumps in the market and benefits from the market’s growth over time.

What is diversification? In a general sense, it’s about spreading your risks around. In investing, that means it’s more than just ensuring you have many holdings. It’s also about having many different kinds of holdings.

While this may make intuitive sense, many investors come to us believing they are well-diversified when they are not. They may own many stocks or stock funds across numerous accounts. However, upon closer analysis, we find that most of their holdings are concentrated in large U.S. company stocks or similarly narrow market exposure. Diversification works because different types of investments react differently as market conditions change. When one investment falls on hard times, others might be performing well and can buoy the overall performance of a portfolio. If all of your holdings are too similar in nature, diversification is unable to work its wonders over time.

So, how do you get smart diversification without overcomplicating your life? Invest in one or a few basic index and index-like ETFs and mutual funds. Seek funds that track and hold a broadly diversified basket of stocks across different asset classes, similar to those in broad market indexes, such as the S&P 500 or the Russell 2000. Favor those with relatively low expense ratios. (These days, your basic, well-diversified index ETF need not cost you more than a fraction of a basis point.) You can build a well-diversified portfolio with just a handful of these sorts of low-cost holdings.

In short:

Investing broadly across assets of various sectors, sizes, and geographies can help you build a resilient portfolio that can better weather the market's ups and downs over time.

Avoid Speculating

Focusing attention on broad market indices can also help you avoid speculative behaviors that tend to have a negative impact on your long-term returns. These include market timing and stock picking.

Attempts at timing the market—buying and selling stocks based on breaking news and short-term market movements—often turn out poorly. Because you’re typically buying into hot trends and selling when conditions are scary, you end up buying when prices are high or selling when prices are low. In both cases, that behavior can take a big bite out of your savings, causing significant setbacks as you work toward your long-term financial goals.

Meanwhile, stock picking can overload your portfolio with too few individual securities. This reduces your diversification and introduces something known as concentration risk. Investors are typically rewarded for taking on systematic risk, or risk inherent to the entire market. Concentration risk is not systematic. Rather, it’s particular to the stock you hold, and as such, you cannot expect to be consistently rewarded for taking it on.

If you hold a large portion of your portfolio in just a few stocks, each holding can have an outsized effect on your portfolio. If something happens to just one of the companies you hold—bankruptcy, for instance—you could lose a big chunk of your savings.

It's also exceedingly difficult to pick stocks that will outperform the broader market over time. Consider that in 2023, more than 70% of companies in the S&P 500 Index underperformed the index. These results vary from year to year. But since a handful of companies often drive most of the stock market’s returns, choosing just when to sell the future losers and buy the next big winners can become an impossible—and often losing—game.

Remember what we learned in part 1 about the power of staying invested and compounding returns. Trying to time the market negates this basic principle. 

In short:

Timing the market can lead you to buy stocks when they’re expensive and lock in losses by selling during downturns. When it comes to stock picking, it’s exceedingly difficult to pick single stocks that will be winners, and holding concentrated stock positions can introduce uncompensated risk to your portfolio. Instead, build a diversified portfolio as part of your long-term financial plan.

Follow a Plan That Fits Your Goals

So, how should you divide up your diversified investments? Start by determining the different uses or buckets of your assets. Based on your personal goals, you will need your money at various times, and depending on this timing, your asset allocation, which is how your portfolio is spread among asset classes, including stocks, bonds, alternatives, and cash, will look different for each bucket. Then, based on each bucket's goals, your risk tolerance, and the time you have to invest, you can make smart diversification choices for your assets.

If you search the internet, you’ll likely come across various rules of thumb to help you choose how to allocate your funds, such as the “your-age-in-bonds” rule. This rule suggests you hold a percentage of bonds equal to your age. A 30-year-old would supposedly hold 30% of their portfolio in bonds and 70% in stocks, for example.

Be wary of rules of thumb like these. They depend on broad averages, not your individual circumstances or purpose for this bucket of money. Also, it can be ill-advised to reconfigure your portfolio too frequently or based on something as distracting as whether you’re 29 or 31 years old. With years ahead of you, if you’re able to remain calm and invested during the market’s inevitable rough patches, a healthy dose of stock market returns can take you far.  

In short:

Build your portfolio based on your personal goals (different buckets), risk tolerance, and time horizon rather than chasing or fleeing hot or cold investments or focusing on generalized rules of thumb.

With the three basic principles for building a strong financial future from part 1 and the three basic investment concepts outlined here, you are on the way to building a strong financial foundation.

Let’s get back to basics!

Learn more about Kimberly Hamlin

Hello! I’m Kim, an associate wealth advisor at Allodium Investment Consultants, located in Minneapolis, MN. I strive to provide an amazing experience for clients and help them find financial freedom so they can live their lives to the fullest. My passion is to simplify complicated financial concepts through clarifying the fundamentals. In my free time, you will find me spending time with my husband Tyler, and son Luke. We love underwater scuba diving, watching our son play sports, and tending to our flower garden.

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.