It has been hard to go anywhere the past few years without hearing about high-flying Internet stocks and how the technology sector has taken the Nasdaq to new levels. But as recent stock market swings attest, what goes up can just as easily come down.
With the market doing wild and crazy things, you need a survival strategy to ensure your peace of mind. You do not want to kick yourself for selling a stock that does keep climbing, or berate yourself for holding a stock that falls dramatically. And you definitely do not want to let market jitters keep you on the sidelines.
So what is an investor to do?
Two surefire strategies to help you sleep at night are diversification and dollar cost averaging.
You do not need stakes in dozens of stocks or mutual funds to properly diversify your portfolio. You just need to cover several industries.
Many of us have been sticking to technology stocks because they have been market favorites in recent years. But it may be a good idea to broaden into other sectors to protect yourself if your soaring tech stocks suddenly dive. For example, you may want to buy the stocks of health care, oil and gas, retail, utility or real estate companies.
Diversifying also means buying stocks of different groups -- that is, stocks of large and small companies, and stocks that are considered growth stocks and those that are considered value stocks. Growth stocks are those of companies that expanding steadily and quickly. Growth stocks -- many tech stocks fall into this group -- can see their share prices rise dramatically. But they can also fall quickly if the market senses that a company will not meet expectations.
Value stocks are those that are less expensively priced. Many value stocks are those of good solid companies that are out of favor at the moment, for reasons specific either to the company or to its sector. If you buy the right value stocks, you stand to make a sizable profit when the company comes back into favor. The risk, of course, is that the company will not turn around.
Because a truly diversified stock portfolio needs about 15 stocks or so, it is far easier to diversify by buying mutual funds. For most people, three to seven funds will provide all the diversification needed.
Another aspect of diversification is expanding your investments beyond stocks. The basic rule of diversification is to hold the main assets: stocks, bonds and cash. When interest rates rise, as they have in recent months, bonds become a more attractive investment, in part because bond prices generally fall when rates rise.
You may choose either long-term, intermediate, or short-term bonds issued by the government, or bonds issued by corporations. It is also possible to buy bond funds, which are mutual funds that invest in bonds. Search for them on Morningstar, or buy individual government bonds through the government on TreasuryDirect.
In general, bonds are a lower-risk investment than stocks and therefore offer a lower return over time. But there are times when lower risk is just what you need. In a volatile market, it makes sense for many investors to put any money they made need in the next few years into bonds instead of stocks.
Dollar Cost Averaging
Dollar cost averaging is a fancy name for investing regularly. The strategy works because when you invest on a schedule -- without regard to current share prices -- you will wind up buying more stock when prices are low and less when prices are high. Over time, that means you will earn a higher return.
All you need to do is to buy shares of stock or a mutual fund every month, for example. Then forget about short-term market moves, confident that in time your investment strategy will be just fine.
Say you put $100 into a mutual fund each month. When the market is flying high, that might mean you get six shares. If the market falls, the same amount might buy you 10 shares. That will lower your cost and increase your ultimate profit when the market moves upward.
Dollar cost averaging cannot make your money immune from deep market slides. Even the most carefully planned portfolio will suffer. But when you consider the alternative -- letting your money stagnate in savings accounts -- you see that investing in any market is the best choice.