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Hand in Hand: Dollar Cost Averaging and Diversification

| January 18, 2018
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When developing a balanced investment portfolio, choosing your investment strategy is a major consideration. Two common approaches are diversification and dollar cost averaging. Both are geared toward helping you create a solid investment portfolio and, together, they may help you achieve your long-term financial goals. 

Diversification—distributing your assets among different investments in different categories—may help protect your investments from large upswings or downswings in the market. For example, if you choose to invest all your money in the stock of one company, your risk may be greater than if you distribute your investment over a number of company stocks. By so doing, you may reduce the risk of financial losses brought on by a downturn in one area. However, keep in mind that asset allocation (and/or diversification) does not ensure a profit or guarantee against loss; it is a method used to help manage risk. 

You can further diversify your portfolio by investing not only in a variety of company stocks, but also in different vehicles, such as bonds and money market accounts. Along the same lines is the concept of asset allocation, which takes diversification to another level. An asset allocation strategy divides assets among various investment categories (stocks, bonds, etc.) in percentages that are aligned with your tolerance for and ability to shoulder risk. For example, using the asset allocation model, an investor’s portfolio might be divided as 20% cash, 20% bonds, and 60% stocks. The allocation of assets should be determined based on a number of factors, including your goals and risk tolerance, as well as your age, tax bracket, financial resources, and liabilities. 

Dollar Cost Averaging

Working in concert with diversification, dollar cost averaging may help increase your chance for financial success. Generally speaking, this strategy involves investing a fixed amount of money at fixed intervals. This, in turn, helps ensure you are paying a lower average cost per share for the security, compared to the average price per share. While this approach cannot assure a profit or protect against a loss, it can help ensure that you will buy more shares when prices are low and fewer shares when prices are high. The key is to make regular purchases, which may be a more reliable approach than trying to project market fluctuations. 

The chart below demonstrates how, investing $100 a month for one year, you would actually pay less per share than the average market price per share. 

                                             Hypothetical          Approximate

                                             Market Price         No. of Shares

Month       Investment       Per Share               Purchased

--------------------------------------------------------------------------------

  1                 $100                    $10                           10.0

  2                 $100                        8                           12.5

  3                 $100                        5                           20.0

  4                 $100                        8                           12.5

  5                 $100                        7                           14.3

  6                 $100                        9                           11.1

  7                 $100                      10                           10.0

  8                 $100                        7                           14.3

  9                 $100                        5                           20.0

10                 $100                        7                           14.3

11                 $100                        8                           12.5

12                 $100                        9                           11.1

                     ------                    -----                         -------

Totals:      $1,200                    $93                         162.6 

Average market price per share:    $7.75 ($93/12)

Average cost per share:                  $7.38 ($1,200/162.6)

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This example is hypothetical. Be aware that investment returns and principal values of stocks and autual funds will fluctuate due to market conditions. Therefore, when shares are redeemed, they may be worth more or less than their original cost. Utilization of the dollar cost averaging strategy does not guarantee the investor will average a lower cost per share. Dollar cost averaging does not ensure a profit nor does it protect against a loss in declining markets. It involves continuous investment in securities regardless of fluctuating price levels. Investors should consider their ability to continue purchases in periods of high prices. 

Stay Your Course

Fluctuating market conditions generate feelings of excitement in some and fear in others. Given the general rule that market corrections will always happen, investors who gear up for the long term may be best prepared to weather tough financial times. Maintaining a diversified portfolio, consistent with your goals and objectives, can help you stay your course, and resist the temptation to act according to market fluctuations.

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