Barbara O’Neill, Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
November 2016
Diversification and Dollar-Cost Averaging: The Basics
Two time-tested investment strategies are diversification and dollar-cost averaging. Diversification means spreading your money among different types of investments (e.g., stocks, bonds, and cash equivalent assets such as CDs and money market funds) to reduce the risk of loss from a decline in any one investment.
There are a number of ways to diversify investments. Below are six frequently used strategies:
-
Place money in different asset classes (e.g., stocks, bonds, cash equivalent assets, and real estate), a strategy known as asset allocation.
-
Choose different investments within each asset class (e.g., stock from different industry sectors such as technology, transportation, and health care).
-
Purchase investments, such as mutual funds and exchange-traded funds, that contain diversified portfolios of stocks and/or bonds.
-
Purchase well-diversified stock and bond index funds that track broad market indices.
-
Purchase a lifestyle mutual fund that includes three asset classes- stock, bonds, and cash- in varying proportions. Investment companies generally offer several portfolios within these funds, each with a different amount of risk. For example, a growth portfolio would hold more stock as a percentage of assets than a moderate growth portfolio or a conservative portfolio.
-
Purchase a lifecycle (target date) fund that manages money toward a future year (e.g., 2040). Target date funds automatically reduce the percentage of stock, and level of risk, in the fund as the target date is approached. No action is required on the part of investors,
Dollar-cost averaging is the practice of investing equal amounts of money (e.g., $50) at a regular time interval (e.g., monthly), regardless of whether the value of investments is moving up or down. A common example is the amount that workers contribute to a tax-deferred retirement plan each pay period. Another is monthly deposits that are automatically debited from a bank account and transferred into a mutual fund investment plan.
Dollar-cost averaging reduces average share costs over time. Investors acquire more shares in periods of declining share prices and fewer shares in periods of higher prices. When dollar-cost averaging is practiced over long time periods, time diversification reduces investment risk.
A simple illustration of dollar-cost averaging can be found in the table below. An investor deposits $50 in an investment each month for six months. The amount of shares purchased varies with the price per share. The average cost per share is $7.06 ($300 in deposits divided by 42.50 shares).
Illustration of Dollar Cost Averaging
|
Time Period |
Regular Investment |
Share Price |
Shares Acquired |
|
Month 1 |
$ 50.00 |
$10.00 |
5.00 |
|
Month 2 |
$ 50.00 |
$ 8.00 |
6.25 |
|
Month 3 |
$ 50.00 |
$ 5.00 |
10.00 |
|
Month 4 |
$ 50.00 |
$ 5.00 |
10.00 |
|
Month 5 |
$ 50.00 |
$ 8.00 |
6.25 |
|
Month 6 |
$ 50.00 |
$10.00 |
5.00 |
|
Total |
$300.00 |
|
42.50 |
For more information about diversification and dollar-cost averaging, visit the eXtension Investing For Your Future home study course: http://www.extension.org/pages/10984/investing-for-your-future.
Check out our Archived Monthly Investing Messages.