Diversification and Dollar-Cost Averaging: Time-Tested Investment Strategies

By Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu

Many military families are faced with investment decisions, such as whether or not to participate in the Thrift Savings Plan (TSP) available to service members or fund an IRA for retirement savings or a 529 plan for their children’s college savings. Some are new to investing and may have many questions about how to get started and how to succeed.

Two time-tested investment strategies are to diversify and dollar-cost average. Diversification means spreading your money among different investments to reduce the risk of loss from a decline in any one investment. There are several easy ways to diversify investments:

  • Place money in different asset classes (e.g., stocks, bonds, cash, and real estate), a strategy known as asset allocation
  • Choose different investments within each asset class (e.g., stock from different industries)
  • 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.
  • Purchase a lifecycle (target date) fund that manages money toward a future year (e.g., 2040) and generally reduces the percentage of stock and level of risk in the fund as the target date is approached. An example is the L fund in the TSP.

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. 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.

 

Leave a Reply

Your email address will not be published. Required fields are marked *