Pilots live in a world of acronyms, so I have a new one for the world of investing: DADR. That stands for:
D – Diversification
A – Asset allocation
D – Dollar cost averaging
R – Rebalancing
Last month’s blog I explained the basics and benefits of diversification. This month I will discuss the other 3 concepts above.
Asset allocation goes hand in hand with diversification. A proper asset allocation attempts to balance the risk and reward tradeoff in a portfolio by adjusting the percentage of each asset class given an investor’s goals and objectives and taking into account risk tolerance and time horizon. A good current example of this is what is currently going on in the markets so far in 2014. Large Cap companies, given their multi-national exposure have started the year off with a slight loss, approximately 1.2% prior to last week’s market loss. On the other hand, the Nasdaq and Russell 2000 were up 1.6% and 1.4% respectively. Being properly allocated lets an investor take advantage of the cyclical nature of certain segments of the market -be it large caps, small caps, mid caps, index funds, global and international funds, emerging markets, bonds, etc.
Dollar cost averaging (DCA) is another important concept for long-term investing. This strategy automatically takes place if one participates in their company’s 401(k) plan and invests regularly and periodically in their accounts. Every month when one’s contributions are made to your 401(k), whether it be once or twice a month, you are purchasing the shares of the mutual funds, stocks, ETF’s, etc., at the price on that given day (more shares are purchased when the share price is low and fewer shares are purchased when the share price is high). As the market moves up and down throughout the months and years, DCA results in a lower cost per share than one would’ve had if the fund or stock was bought in a bulk lump sum say only once or twice a year. This strategy lessens the risk of a large capital investment at the wrong time and spreads your risk out over the time horizon. You’ve heard “ a rising tide lifts all boats”. What DCA does is makes that boat larger so there is more mass to lift up if the markets rise over time.
Rebalancing is similar to having your car run slightly off the road and you adjust it to get it back on track. This is an extremely important strategy to the long-term success of one’s portfolio. Some retirement plans and IRA’s have an automatic rebalance feature and some do not. It’s important for you to know whether this needs to be done manually. If you work with a financial advisor, this would normally be done for you at regular intervals to make sure you’re on the track established for your individual goals and objectives. Rebalancing involves the periodic buying and selling of assets in one’s portfolio to maintain the original desired level of asset allocation. If one asset class performs better than another within a portfolio, then the allocation becomes out of whack with the plan and requires adjustment. I, personally, like to rebalance my client’s retirement portfolios twice a year. This gives time for certain sectors or asset classes to appreciate, or depreciate. Having an automatic rebalancing plan, instead of a manual one, takes out the psychological aspect of having to sell your winners and buy your losers – which essentially is what is happening when you rebalance. You may not want to sell your winners and believe they will continue to move upward – this is exactly the opposite of what a prudent long-term investor should do and having the benefit of an auto rebalance program negates this threat as markets and stocks do not climb forever.