Examples of Diversification and Dollar Cost Averaging
Investing in the stock market can provide better returns than cash or fixed instruments such as bonds, but it also carries greater risk of loss of principle. Long-term investors can mitigate that risk by using the strategies of diversification and dollar cost averaging.
Positives of Diversification
Although no strategy can completely eliminate the risk of loss in a non-insured investment, a truly diversified portfolio can result in investment returns even when some parts of the market are declining.
Diversification works well for investors whose goal is to preserve funds over a long time frame. For investors who need a high quick return and are willing to take a high risk for it, focusing on a particular area can bring higher returns, but may result in large losses.
Definition of Diversification
The key to diversification is to hold different types of investments at the same time. It is more than just holding two different stocks or two different mutual funds. The investments need to react differently in the same market.
An all stock portfolio is at risk of a general market decline. A truly diversified portfolio may include diverse assets such as bonds, real estate, precious metals, commodities, loans and certificates of deposit.
For instance, prices for precious metals will often increase during political unrest, which has a dampening effect on stock prices. Real estate can provide income, but is considerably risky and very illiquid, that is, very difficult to sell and turn into cash.
Having a number of different types of investments can provide stability to an investment portfolio over a several year period. Results may be less than a single investment during bull markets, but over several business cycles, will have more consistent returns.
Dollar Cost Averaging
Prices of investments fluctuate over both the short and long term. The concept of dollar cost averaging is to buy the same amount of an investment over a period of time. The most common method is to buy a certain amount of a mutual fund every month, or a number of shares of a stock over several days.
Less commonly used is the strategy to sell an investment in increments. The same principles of fluctuation apply when selling.
Averaging will reduce the impact of short term fluctuation. Negatives to averaging are missed opportunities when fluctuation is the investor’s favor, and the cost of commissions. Some investments, like real estate, are difficult to average into.
The Time Value of Money
The time value of money is a basic concept of investing. Money promised in the future is worth less than the same money held today. Therefore, investments are designed to return more money later than the investor puts in now.
Due to market fluctuations and differing qualities of investments, it does not always work that way. Diversifying and mitigating fluctuations through dollar cost averaging can help.