THERE ARE TIMES when investing looks like such a sure thing that limiting your rewards with any sort of defensive strategy seems foolish. But venturing into the markets fully exposed is like giving up your health insurance policy to pay for a family hiking trip -- one slip, and you're done for.
As we discussed in Time vs. Risk, the longer you have to invest, the more the clock will make up for the inevitable short-term losses. But these three classic defensive strategies are still crucial if you want to maximize your gains while limiting your risk.
The single best way to protect yourself from a meltdown in one stock or industry is to spread your risk across several different investments. The more diversified your portfolio is, the less any one stock can hurt you by blowing up.
If you've got the time and energy, you can create your own diversified portfolio. But it will mean keeping track of at least 20 different stocks or bonds at once -- a daunting task, to say the least. A much easier solution is to buy a range of mutual funds and leave the diversification worries up to professional management. As we discuss in depth in our Mutual Fund section, by purchasing a fund that invests in large, blue-chip companies, another that looks for smaller growth companies and yet another that invests overseas, you can easily spread your money across hundreds of separate stocks. You'll pay a little in fees, but the savings in time and aggravation are probably worth it.
Dollar-cost averaging is another form of diversification -- only instead of spreading your money over a bunch of different stocks or bonds, it diversifies your investments over time. The natural human tendency is to buy lots of stock when prices are rising and to stop buying them altogether when prices are on the downswing. Dollar-cost averaging forces you to do the opposite -- you end up buying the most stock when prices are low.
Here's how it works: Suppose you decide to put $300 a month into a mutual fund that invests in the stocks of large companies. Your broker or fund company can set up an account for you and the money is pulled straight from your paycheck on the same day each month. After a while, you hardly know it's gone.
If a share of the fund costs $50 in October, your $300 will buy six shares. If the price rises to $75 in November, you buy four shares. If the price drops to $25 in December you buy 12 shares. The idea is that your money buys more shares when the price is cheap and fewer when the price is high. That lowers your total cost and, assuming the fund's overall trendline is upward, you capture more of the upside.
That's not to say dollar-cost averaging protects you from a falling market. If the fund's value crashes, so does your overall investment. But the strategy does ensure that you invest new money when prices are low so that you can enjoy the runup when the market recovers -- as it always does with time.
A lot of people also use dollar-cost averaging when they want to move a big chunk of money into the market -- an inheritance, say, or a year-end bonus. The idea here is to protect yourself from putting all your money in at once and having the market crash days or weeks later. It's true that if the market moves sharply higher, you've missed an opportunity. But in volatile times, that risk is worth it.
Of course, if you're moving money from one stock account to another -- as many people do when they change jobs and roll over their 401(k) accounts -- dollar-cost averaging doesn't make much sense. If your money is already in stocks, you're not assuming any more risk if you simply transfer it into a new account.
Asset allocation is yet another way to diversify. It takes advantage of the fact that when it comes to risk and reward, financial categories like stocks, bonds and money-market accounts all behave quite differently.
Stocks, for instance, offer the highest returns among those three "asset classes," but they also carry the highest risk of losses. Bonds aren't so lucrative, but they offer a lot more stability than stocks. Money-market returns are puny, but you'll never lose your initial investment. An asset-allocation strategy looks at your particular goals and circumstances and determines what asset mix gives you the optimal blend of risk and reward.
Here's an example. Say your goal is retirement. When you're young -- in your 20s or 30s -- and have time to make up for short-term market losses, an asset-allocation scheme would put you heavily into stocks, maybe 100% of your savings. You might even spice it up with a mix of large-company stocks, small-company stocks and international stocks to diversify your exposure within the category.
As you moved into your late 30s and early 40s, however, you'd probably want to add some bonds to give your portfolio some stability and income. Maybe you'd shift to a 75/25 blend -- still favoring growth, but not overdoing it. The closer you got to retirement age, the more you would ratchet up the bonds and taper off the stocks. And in your last few years, when you simply could not afford big market losses, your portfolio would be heavy on short-term bonds or money-market funds -- the least risky of all investments.
If you're serious about it, allocation models also help you buy low and sell high. Say, for instance, small-company stocks are on fire one year, but large-company stocks are merely standing still. If the stock portion of your allocation model called for a 50/50 mix between the two, this sudden surge in small-company values would upset the balance. To make things right again, you'd have to sell some expensive small-company stock and buy some cheaper large companies. If you "rebalanced" this way each year, you'd always be trading expensive assets for those with more growth potential.