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Diversification across asset classes—or asset
allocation—is one of the most powerful strategies
investors use to accomplish their goals. Besides dividing your
investment dollars among different asset classes such as stocks,
bonds and real estate, you also can allocate them among
subclasses—for example, high-growth stocks and high-income
stocks. Remember, dividing your investment dollars among three
high-growth technology stocks does not equal asset allocation.
Sometimes investors use a buy and hold strategy
in conjunction with asset allocation. They reason that most
declines in securities markets are temporary, so a long-term
investment strategy ensures the best overall return. Even if the
worst happens, and, for example, you must sell all your diversified
stocks during a general decline in the stock market, you may still
realize considerable profit if you have held those stocks for a
long period. Since the stock market as a whole has grown steadily
over the years, a dip in the average price of stocks today still
leaves the average price much higher than it was 20 years ago.
Another conservative approach that some investors use in
combination with a buy and hold strategy is dollar cost
averaging. In this case, the investor regularly invests a
set amount on a set schedule. For example, the investor might
invest $200 every month into mutual funds. If the price of the fund
is high, the investor buys fewer shares; if the price is low, he or
she buys more shares. This strategy has an effect similar to that
of the buy and hold strategy, with time working to "even out" the
highs and lows of the market. Over time, the investor often will
accumulate a sizable portfolio.
In contrast, a market timing strategy requires
investors to trade securities to take advantage of short-term
market cycles. Market timers buy a security when it is priced low
(in a trough) and then sell it when it is priced
high (at a peak) just before the market turns down
again. They might then buy back the security after the market drops
again. Investors who use market timing frequently look to various
factors as a guide for imminent changes in direction or
accelerations in the movement of security prices. These factors can
include political and industry announcements, interest rate
changes, and economic factors such as the inflation rate or number
of new houses being constructed. Market timing requires more active
portfolio management than a buy and hold strategy.
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