Investing Step 10: Techniques

This post is step 10 in our Investing Template.

Once you’ve decided how your money should be allocated, it then becomes a matter of execution.  There are many details that can make a tremendous difference in how your returns are realized.  How you get your money into its allocation is nearly as important as what allocation you choose.

Diversification

Diversification is a term you hear a lot.  It basically means making sure all your eggs are not in one basket.  While economic crises can affect all asset classes, in general when one does poorly, another does well.  Thus if you have your money in a variety of areas, you will generally get better returns.  Additionally, this applies to stock and is a compelling reason to buy mutual funds. 

Index Funds

Once you’ve settled on buying mutual funds, index funds are often a very reasonable approach.  Their goal is to roughly match the returns of various well known stock market indexes like the S&P 500 or the Dow Jones Industrial Average.  By buying into an index fund, you have gotten a tremendous amount of diversity in your stocks.  Additionally because they are essentially unmanaged, you are paying low maintenance fees and not subject to your money manager’s strategy becoming outdated.

Dollar Cost Averaging

Fortunately, for many of us this happens naturally due to the way 401(k) contributions are handled, but for the rest of us this can be very important.  Timing the market is a dicey proposition for experts, so for those of us simply trying to get reasonable returns it is a terrible idea to put all our money into a particular investment vehicle at once.  Instead the goal is to buy a fixed dollar amount of each vehicle every so often, maybe every month.  As a result, you will buy more when the price is lower and less when the price is higher.  This should help prevent catastrophic entry points and your average price should be favorable.

Rebalancing

Another technique is rebalancing your asset classes periodically.  Say you had been allocating 50% to stocks and 50% to bonds (not necessarily a good strategy, but easy for our example).  If during the first period of time stocks had done very well and bonds very poorly, your portfolio might now be allocated 65% stocks and 35% bonds.  By rebalancing, you move funds from the over-performing sector to the under-performing sector.  If this is not done too frequently, it can allow you to take part in the recovery of the laggard.

 

2 Responses to “Investing Step 10: Techniques”

  1. Equity Sweat says:

    Reallocation always sounds good on paper, but I find it often results in moving funds to under-performers just so that they can underperform some more. Now when it comes to reallocating due to “phase of life” I’m in 100% agreement.

  2. Brad says:

    I think that’s a fair point that you certainly should not rebalance too often. You don’t want to cut off the upside of an asset class when it’s just getting going.

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