In addition to long-term compounding and riding out market volatility, which I talked about in my last blog, there are a few more strategies that may help you reach your objective of maximizing gains and minimizing losses.
Asset allocation means spreading one’s dollars over several categories of investments, known as asset classes. Among the most common are stocks, bonds, and cash.
The reason for asset allocation is that no single asset class can provide an investor with everything needed to meet his or her goals. While each asset class has its advantages – and its challenges, a diversified portfolio that includes various asset classes has shown, over time, to help smooth out the effects of market volatility. Obviously, it avoids the risk inherent in choosing one single asset class that may -- or may not -- perform well enough to meet one’s objectives.
Today’s economy features many financial factors, such as taxes, inflation, market changes, political climate, and the like. Each asset class has its own reaction to changes in these individual factors, and these sometimes affect an investment in opposite ways. Diversification provides a layer of insulation in such situations, often helping to minimize the overall impact on one’s portfolio.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.
Liquidity in investment choices
We financial advisors sometimes refer to embedding liquidity in investment choices as a “bucket strategy.” Basically, this means dividing your portfolio into three “buckets” – one to address short-term needs, one for intermediate term needs, and one to address long-term goals.
The short-term bucket is to meet unexpected emergency needs or opportunities, and generally may target a one-to-three-year timeframe. These assets may be in cash or in assets that can readily be converted to cash. They likely will not have great growth potential, but the principal will be relatively safe, quickly available, and less affected by daily market conditions.
The intermediate-term bucket is used to meet goals that might not be clearly defined at the moment but are still being developed. Eventually, these could turn into short-term or long-term goals. While this process is under way, the intermediate-term investments are working for you. Some may refer to the intermediate-term bucket as a “rainy day” fund.
The longer-term bucket is for investments that you don’t expect to touch. Typically, longer-term investments provide more opportunity for tax advantages and also allow for a more aggressive strategy to achieve desired growth.
This “three-bucket” approach provides the liquidity to meet short-term needs instead of having to draw from intermediate or longer-term investments at inopportune times. In other words, it allows you to stick with your plans.
Investments are subject to risk, including the loss of principal. Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved.
Dollar cost averaging
Many people are familiar with this concept because this is how they save in their employer retirement plans. A fixed-dollar amount is taken from their pay on a scheduled basis and goes into a retirement plan, where the funds are used to purchase shares of stock or a mutual fund.
This method allows the purchaser to take advantage of fluctuations in the markets. When the market is high, the fixed-dollar amount will buy fewer shares. When the market is lower, the same fixed-dollar amount will buy a higher number of shares. When the market recovers, the shares bought at the lower price increase in value, while those purchased at a higher price remain about the same. As a result, the value of the portfolio increases.
Ironically, instead of worrying about market volatility, dollar cost averaging allows you to turn that volatility into a financial advantage. While it might be difficult to pick the right times to “jump into and out of the market,“ buying shares on a consistent basis with a consistent amount allows you to take advantage of the reality of the market.
Systematic investment plans do not assure a profit or protect against loss in declining markets. Such plans involve continuous investment, regardless of market conditions. Markets will fluctuate, and clients must consider their ability to continue investing during periods of low price levels. Investments are subject to risk, including the loss of principal.
Buy and hold – but don’t buy and forget!
Once you have established a set of smart goals and developed a portfolio strategically designed to achieve them, you have one more important action to take: you must periodically review your portfolio.
To use a simple analogy, think of a garden. After it is planted, it needs periodic care – watering, weeding, pruning, and so forth. The same is true of a good portfolio. Factors change with time, and the portfolio should account for those changes.
For example, asset classes have varying rates of return. If left completely alone, a diversified portfolio my unintentionally become more aggressive or more conservative. In short, it is important to periodically rebalance and reallocate assets as necessary to provide the maximum opportunity for meeting your goals.