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. Diversification, the principle of not putting all of your eggs in one basket, applies to life in general and to investing in particular.
Financial diversification – dividing an account into different categories of investment vehicles – improves a portfolio. Since you can never predict market performance, a good investment strategy is to hedge your bets. If you agree with the philosophy of spreading out risk, what practical steps should you take? Once you find a good investment that fits in with your diversification model, what is the best way to buy it?
Sometimes a particular asset class looks great and you want to invest in it, but you may be fearful about the future. Is it best to buy a lot of the investment now, or to buy a bit, wait, and then buy a little more?
Consider the strategy 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. Every month, you may buy $1000 worth of stock, buying a different number of shares with each transaction. Over time, you can buy more shares at a lower price and fewer shares at a higher price.
Dollar cost averaging can be applied to many types of investments, including stocks and bonds, Exchange Traded Funds, and mutual funds. Spreading out your investment purchases can give greater flexibility while smoothing out volatility.
Often, I recommend to clients who are just beginning to invest that they use dollar cost averaging to gently test the waters of the market. This way, they can measure their reactions to volatility at the same time that they build well-diversified portfolios. Click here to learn more about dollar cost averaging.
Published June 30, 2022.