Defensive Investing Strategy

These three classic defensive strategies are crucial if you want to maximize your gains while limiting your risk.

Diversification
The single best way to protect yourself from a meltdown in one stock or industry is to spread your risk across several different investments. The more diversified your portfolio is, the less any one stock can hurt you by blowing up.

If you've got the time and energy, you can create your own diversified portfolio. But it will mean keeping track of at least 20 different stocks or bonds at once -- a daunting task, to say the least. A much easier solution is to buy a range of mutual funds and leave the diversification worries up to professional management. As we discuss in depth in our Mutual Fund section, by purchasing a fund that invests in large, blue-chip companies, another that looks for smaller growth companies and yet another that invests overseas, you can easily spread your money across hundreds of separate stocks. You'll pay a little in fees, but the savings in time and aggravation are probably worth it.

Cost Averaging
Cost averaging is another form of diversification -- only instead of spreading your money over a bunch of different stocks or bonds, it diversifies your investments over time. The natural human tendency is to buy lots of stock when prices are rising and to stop buying them altogether when prices are on the downswing. Cost averaging forces you to do the opposite -- you end up buying the most stock when prices are low.

A lot of people also use dollar-cost averaging when they want to move a big chunk of money into the market -- an inheritance, say, or a year-end bonus. The idea here is to protect yourself from putting all your money in at once and having the market crash days or weeks later. It's true that if the market moves sharply higher, you've missed an opportunity. But in volatile times, that risk is worth it.

Asset Allocation
Asset allocation is yet another way to diversify. It takes advantage of the fact that when it comes to risk and reward, financial categories like stocks, bonds and money-market accounts all behave quite differently.

Stocks, for instance, offer the highest returns among those three "asset classes," but they also carry the highest risk of losses. Bonds aren't so lucrative, but they offer a lot more stability than stocks. Money-market returns are puny, but you'll never lose your initial investment. An asset-allocation strategy looks at your particular goals and circumstances and determines what asset mix gives you the optimal blend of risk and reward.