The principle of not putting all of your eggs in one basket applies to life in general, and particularly investing. You don’t have to be an egg farmer or a Nobel Prize winner to understand the sense in planning your finances carefully and not putting all of your money in one place in order to spread out the risk.
The principle of diversification, which means building a portfolio that is divided into certain categories of investment vehicles, is a very useful tool in investing. Primarily, since you never know how the market is going to perform from one period to the next, it may be a good idea to hedge your bets. Sometimes acting to prevent losses also means limiting gains. But what does this really mean? Once you find a good investment that fits in your diversification model, what is the best way to buy it?
Building a ladder
Sometimes a particular asset class looks great at the moment, and you want to invest in it, but you are fearful about the unpredictable future. Is it best to buy a lot of the investment now, or to buy a bit, wait and see how it performs, and then buy/sell more?
In such a case, you could follow the practice of “dollar cost averaging.” This is when you buy an investment at predetermined intervals. This kind of “time diversification” may be safer than buying a single large position at once. At set intervals you purchase a set amount of the investment. Every month, you may buy $1000 worth of stock, buying a different number of shares each time. Statistically, over time this strategy buys the most number of shares at a lower price. Imagine that each time you buy into the particular investment is a rung on a ladder, and gradually you will hopefully build yourself a stairway towards some eventual profits.
This kind of practice can be applied to many kinds of investments, such as a mutual fund, a CD, or a bond portfolio. Spreading and laddering your investments in this way can give you more flexibility while smoothing out some level of volatility.
Often I recommend to clients who are just beginning to invest that they implement dollar cost averaging to let them gently test the waters of the market. This way, they can measure their reactions to the market’s movements at the same time that they build well-diversified portfolio. If you are unhappy with the level of volatility in your portfolio, or your portfolio’s performance, consider implementing a dollar cost averaging strategy.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published June 5, 2012.