There are two basic strategies that can help you reduce the risk in your college funding portfolio: diversification and dollar-cost averaging. These two strategies can be accomplished simply through a regular saving plan—you have the opportunity to invest in different investment funds (diversification), and you contribute money gradually (dollar-cost averaging).
Diversification means don't put all your eggs in one basket. Investment experts say it is suitable to invest in a number of different vehicles. You want to have your money in many different kinds of investments, so that if anything happens to any one of them, it won't be a disaster. Diversification helps minimize the risk in your investments.
Asset allocation is a method of diversifying your investments to help you work towards the highest rate of return for the amount of risk you are willing to accept. Since no one can predict what will happen tomorrow, you need a way of investing your money to pursue your long-term goals. Rather than focusing on current market conditions and the short-term outlook, you need a strategy that is based on what stage of life you are at and how many years you are from starting to require the funds.
Asset allocation is based on two simple concepts. First, different asset classes—stocks, bonds, and cash—react differently under the same economic conditions. For example, stocks tend to do well when inflation is low and interest rates are dropping. Bonds tend to perform well when the economy is slowing down and the price of stocks may be falling. And cash, while not a growth asset, can act as an anchor when both stocks and bonds are performing poorly.
Second, certain asset classes perform better over time than others. As you know by now, stocks have historically outperformed over the long-term, but have the highest degree of short-term volatility. Bonds with short-term maturities typically show less price volatility to changing interest rates than bonds with longer maturities.
Here's the basic point: By selecting a combination of stock and bonds, you smooth out the short-term volatility—the ups and downs of the markets—while seeking to achieve your long-term goals. Since each asset class has historically achieved certain rates of return over certain periods of time, we can assume certain combinations—ratios of stocks, bonds and cash—will produce certain long-term results based on past performance, although actual results will vary and cannot be guaranteed.
IMPORTANT NOTE: Although Asset Allocation Strategies seek to minimize short term volatility, they do not ensure against loss or protect against loss in a declining market. Past performance is no guarantee of future results. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The strategy of systematically investing a fixed dollar amount over time is called dollar-cost averaging. For example, if you have $1,200 to invest in your college funding program this year, you would invest $100 per month instead of investing the whole $1,200 at the beginning of the year. The benefit of dollar-cost averaging is that it reduces the risk of buying shares at the wrong time—when stock prices are high. The theory is that you buy fewer shares when the price per share is higher and more shares when the price per share is lower. Dollar-cost averaging can work in your favor because the average price per share that you end up purchasing may be lower. This is the principle used in investing in company savings plans through payroll deductions.
IMPORTANT NOTE: Regular investing does not guarantee a profit or protect against loss in a declining market. This plan involves continuous investments in securities regardless of fluctuating price levels and you should consider your ability to continue through periods of low price levels.