Financial magazines often use the words “secret” and “hot” on their covers (e.g., “10 Secret Investing Strategies” and “5 Hot Funds for 2007”) as an enticement to lure potential readers. Nobody wants to be left out of information provided by those “in the know.” The problem, however, is that there are rarely any secrets on Wall Street. Stock prices generally reflect all known and expected earnings information about a company. Barring any “insider information,” which is illegal for company insiders to disclose, stocks are typically priced fairly and usually contain few surprises to those who follow company earnings reports in Value Line and other sources.
If there really are no investment secrets, is there anything that investors can do to accumulate wealth over time? Two commonly recommended investment strategies are diversification and dollar-cost averaging. While neither is a secret, nor are they new, they have been shown to build wealth and reduce investment risk. Like many successful investment practices, diversification and dollar-cost averaging have proved to work over time and have, thus, been recommended to generations of investors.
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 several asset classes (e.g., stocks, bonds, cash equivalents, and real estate), a strategy known as asset allocation.
• Choose different investments within each asset class (e.g., stock from different industries such as technology, transportation, and health care).
• Purchase investments, such as mutual funds and exchange-traded funds, that contain diversified portfolios of stocks or bonds.
• Purchase stock and bond index funds that track broad market indices such as the Standard & Poor’s 500.
• Purchase a mutual fund that includes a variety of asset classes—typically, stock, bonds, and cash. A popular type of mutual fund, called a life-cycle or target date fund, has a future date (e.g., 2030) in the title and automatically becomes more conservative as investors get older and approach retirement.
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 their tax-deferred retirement 401(k) or 403(b) 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.