REDUCE INVESTMENT RISK THROUGH DOLLAR COST AVERAGING, REBALANCING

Reduce Investment Risk through Dollar Cost Averaging, Rebalancing
By Steve Moore

Following the stock market this year has been interesting. After three years of solid market growth, the market corrected itself. Now, it seems like a roller coaster ride as it is not uncommon for the Dow to be up or down two percent on any given day.

A recent issue of The Source, R&M’s e-newsletter, carried an article that discussed the benefits of diversifying a portfolio with assets that have a low correlation amongst themselves. This is called diversification. Okay, now that the portfolio is designed, it's ready for investing. Should one jump right in and invest 100% of the proceeds immediately? Maybe, or maybe not. It depends on personal risk aversion. What's the danger in losing money in the short-term? What steps can be taken to reduce the risk of the portfolio while actually investing or even after fully invested?

The first concept is called dollar cost averaging. Here's an example of how it works. An investor has $25,000 ready to invest and has decided which funds to use as investment vehicles. Instead of investing the full $25,000 immediately, the investor decides that, because the market is volatile, he will park the $25,000 in a money market account earning 4%. Every month he sweeps $2,000 from the money market account into a mutual fund portfolio. It will take about one full year to become fully invested. By doing this, he protects himself from a big dip in the market the week after investing the full $25,000. So, there is downside protection in the short-run. However, the investor is also are giving up any immediate market appreciation, as he only invested $2,000 and not the full $25,000. This is a sound strategy in an uncertain market. One might even consider this strategy within a 401k plan.

The second concept is simply re-balancing a portfolio on a regular basis (quarterly, semi-annually, or annually). One just needs to look at the bear market of 2000 through 2002 to see how this works. Assume one starts with a 50% allocation in US Stocks and 15% in real estate. As US stocks lose value and real estate appreciates, the portfolio allocation may be 42% US stocks and 23% real estate at the end of year 2000. Now, to rebalance the portfolio, take money away from real estate and add it to US stocks. This is important because rebalancing forces the investor to sell the winners and buy back into the losers. This is also known as selling high and buying low. Not rebalancing allows for greater gains but, more importantly, much greater risk. The idea is to get market-like returns with as little risk as possible. Dollar cost averaging and regular rebalancing are two great ways to take the extra step of risk reduction.

Mr. Moore may be reached at smoore@rubino.com. For more information about Rubino & McGeehin, please visit http://www.rubino.com/.