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Investment Risk Management: Asset Allocation and Dollar-Cost Averaging Thumbnail

Investment Risk Management: Asset Allocation and Dollar-Cost Averaging

Whether your retirement is years away or right around the corner, your investment portfolio should be designed with your financial goals in mind. It needs to be forward-thinking enough to handle the whims of the market but flexible enough to make adjustments when appropriate.

Asset Allocation

One of the most important concepts for any investor to understand is asset allocation. Put simply, asset allocation describes the division of stocks, bonds, and cash that make up your  portfolio. Although this concept is straightforward, it has one of the largest impacts on your financial future.

Each asset class has its own set of risks and rewards, depending on your time horizon, cash flow needs and financial goals. 

  • Stocks allow you to own a share of publicly traded companies. By investing in stocks, you have the potential for a higher return on your investment in exchange for the inevitable volatility that will come your way. Bonds, overall, have been a steadier source of fixed income. However, as we have seen this year, bonds are subject to interest rate and inflation risks, and their rate of return tends to be lower.
  • Mutual funds and ETFs (exchange-traded funds) make it a bit easier to diversify.  They are pools of multiple companies. While many mutual funds have a mix of stocks and bonds, some specialize in one or the other. Mutual funds offer less risk than investing directly in stocks, because the diversification they offer tends to spread the risk.

Cash and cash equivalents give you the ability to fund your spending needs without being forced to liquidate assets help for longer term goals.  In addition, having some cash on hand gives you the flexibility to meet unexpected emergencies that may arise. If your hot water heater dies, having funds on hand to take care of it without resorting to a credit card is helpful. 

Dollar-Cost Averaging

One way to take the stress out of deciding when to invest funds into the market is to dollar-cost–average. In dollar-cost averaging, you invest a set amount of money into your investment portfolio over regular intervals. Rather than investing a large sum of money at once, dollar-cost averaging allows you to invest gradually without a huge outlay of capital at any one period of time. Dollar-cost averaging allows you to buy more during market slumps and less when the markets are high, without trying to “play” the market in the short term.

There are several benefits to dollar-cost averaging as an investment strategy. Dollar-cost averaging can help you:

  • Buy more shares: Over the long term, the price of assets will ebb and flow, but generally trends higher over the long term. By using dollar-cost averaging, you may be able to use the volatility of the market to buy more shares over time than if you made a big one-time purchase.
  • Invest consistently: Dollar-cost averaging helps you maintain consistency with your investing strategy. If you’re setting aside pre-tax dollars to invest in a company-sponsored 401(k), for example, you’re already making use of dollar-cost averaging.
  • Set it and forget it: Rather than trying to time the market in the short term, dollar-cost averaging allows you to invest in assets that are more likely to have staying power. This is an especially useful strategy if the idea of monitoring the stock market makes you queasy.

Lump-Sum Investing

However, there is research that shows that over the very long term, lump sum investing can outperform dollar-cost averaging. If you get a bonus or a sudden inheritance in general, you may be better off investing it as soon as possible. While returns aren’t guaranteed, it’s also more likely that you’ll see a return over having that money accrue minimal interest in a bank.

Even then, there are some key caveats. While lump-sum investing outperforms dollar-cost averaging most of the time, dollar-cost averaging still wins out in one-third of cases. The idea of investing a large sum of money at once can be intimidating to many investors, so it’s important to get an outside perspective to help you think with a clear head.

Who Should Use Dollar-Cost Averaging?

Dollar-cost averaging is a strategy that can best help beginner investors, or those without much money to invest at the outset. If you’re investing for the long term and aren’t comfortable with the research that goes into the financial market, dollar-cost averaging is a safer way to get started with investing. However, if you’re investing for the short term, or have a lump sum to invest, you might want to pursue another investing strategy.

Depending on your personal financial situation, dollar-cost averaging may be a smart strategy for you—or if market conditions are favorable, it may make more sense to invest a large amount of capital at once. For most people, the financial strategy lies somewhere in between. Your HCM Advisor can help you decide which strategy is the best for you.

When it comes to managing your portfolio, asset allocation requires a disciplined rebalancing strategy. “Setting it and forgetting it” may sound appealing, but changes in the market warrant a portfolio regular reviews to make sure your asset allocation still makes sense. Your HCM Advisor can help you make sure that your asset allocation reflects your goals.

Steve Hengehold Headshot Steve Hengehold CFP® RICP®
Steve has been with HCM since 2014. He is dedicated to helping people understand their necessary commitments and moving them towards their goals. He loves helping clients to focus on their passions. When not at work, Steve enjoys playing guitar, reading, deferring taxes, compounding investment returns, fishing and SCUBA diving.
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