No matter how the stock market performs, there are ways to help minimize risk and generate long-term growth for your investments. One way to do this is by adding diversification to your overall investing strategy.
What is Diversification?
You've heard the old saying "Don't put all your eggs in one basket"? Diversification is just that. Investing in a variety of assets will help your portfolio weather the market's ups and downs. That's because different investments behave differently under the same market conditions.
For instance, stocks historically have had the highest average returns among the three asset classes of stocks, bonds and cash but come with more risk. Bonds usually are less risky although the returns aren't as high. Cash or cash equivalents such as share certificates, money market accounts or treasury bills while safe, usually offer the lowest long-term returns.
Understanding more about creating a balanced investing mix can help build wealth over time.
Here are six tips to help with your strategy.
1. Know Your Goals, Investing Timeline and Risk Tolerance
By understanding your financial goals, investing time horizon and tolerance for risk, you can create a diversified portfolio tailored to your needs and minimize investing mistakes. As a younger investor, you can take more risks because time is on your side. Over the years, you'll most likely adjust your investing strategy to become more moderate, then conservative as you get closer to retiring.
The sooner you start investing for the future, the better. That's because of compounding growth. When you invest even small increments and stay invested, there can be growth and then growth on that growth. That's why it's said that time in the stock market matters more than trying to time the market.
2. Take Advantage of Dollar Cost Averaging
Once you are investing regularly, a common rule of thumb is to put 10% of your pretax dollars toward retirement savings, like an IRA, 401(k), 403(b) or 457(b). Even if you start out with a lesser amount, commit to contributing a set amount of money each month. This investment strategy, known as dollar-cost-averaging, means you're set up to buy more investment shares when prices are lower and less when prices are higher. In addition, you don't have to make any decisions here, it happens automatically because of your regular contributions.
Dollar-cost-averaging doesn't assure a profit or protect against loss in declining markets. Since dollar-cost-averaging involves continued investing regardless of fluctuating securities prices, you should consider the ability to continue purchases over an extended timeframe.
3. Build a Diversified Portfolio
Even if you have professional guidance for your investments, knowing your options can help you become more confident about investing. Here are some typical investments:
Mutual funds are an efficient way to put diversification into action. They contain stocks, bonds, and other investment products. You can choose from a variety of funds, some with less risk than others. Funds that are actively managed by fund managers use specific strategies to outperform the market. Index funds seek to mirror the performance of indexes.
Like mutual funds, ETFs also offer diversification. The funds trade on exchanges and track a specific index like the S&P 500. While you can buy and sell mutual funds using dollar amounts, you buy and sell ETFs using full shares based on the market price.
When you buy a stock, your shares make you a part owner in the company. Shareholders benefit if the company's value goes up. Stocks can offer greater rewards but come with more risks.
Buying a bond is like loaning money for a set period to a company or the government. You receive your initial investment back in full at the end of the bond period; interest is paid at set intervals throughout the bond period. Bonds are often used for diversification because they provide less risk and predictable returns.
Buying a commodity typically means you're investing in either agriculture, energy, livestock, or metal. When the price of the commodity changes, so does the value of your investment. Over time, commodities offer diversification because they don't perform the same as stocks and bonds.
Real Estate Investment Trusts, or REITs offer diversification because they allow you to invest in income-producing real estate. You can benefit from the income large commercial real estate companies make without owning commercial real estate yourself.
Cash investing is generally used as a secure and temporary place to earn interest until you decide where to invest it. Typical cash investments include money market accounts, treasury bills, certificates of deposit (CDs) or share certificates.
You can invest in money market funds and CDs inside your investing account. You can also open CDs at banks or share certificates at credit unions. Both offer higher interest rates than regular savings accounts, and interest rates are typically fixed.
That means that even if interest rates drop while your money is in an account, your deposit will continue earning interest at the original rate. When the term on your CD or share certificate ends, you can withdraw your principal and earnings or reinvest them in another account.
4. Asset Allocation Matters
By choosing an asset allocation approach to investing, you automatically diversify your portfolio. That's because you choose what to invest in based on your investing timeline, goals and risk tolerance. As your needs change, you can review and adjust your asset choices. It's important to know what kind of investor you are. For instance, you may feel comfortable taking more risk. Or maybe you're more conservative. You can choose your investments based on your investing personality.
5. Stay Invested
When you set an investment strategy, keep perspective, and don't worry over your choices. The market will have drops, some more dramatic than others. But if you withdraw your investments during periods of volatility you miss out on the market's potential gains. Having a diversified portfolio will help you mitigate risk and be positioned to take advantage of the upturns.
6. Think Long Term
Investing is designed to build wealth over time. That's why it's important to establish financial goals and ways you can save for goals like buying a home, as well as retirement. Don't make decisions based on short-term market volatility. Review your investments at least once or twice a year to see if you need to make any adjustments.