To properly diversify across assets means, in a nutshell, to spread your money across a variety of investments. In that way, poor performance in one investment can be offset by gains in another investment.

While diversification usually refers to "what" you buy—stocks, bonds, mutual funds—diversification can also apply to "how" you buy. For example, investing all your money at once leaves you vulnerable to committing your assets at what might turn out to be the exact worst time to be investing. Conversely, perhaps you'll get lucky and pick the absolute best time to buying stocks. Nevertheless, it seems a riskier proposition to pick a single point in time to invest. I'd rather employ time diversification by spreading out my investments over time.

An excellent tool for time diversification is "dollar-cost averaging." Dollar-cost averaging means that you make fixed dollar investments on a regular basis, perhaps every month or every quarter. The beauty of dollar-cost averaging is that it forces you to buy more shares when stocks are cheaper and fewer shares when stocks are more expensive. Another benefit is that dollar-cost averaging strips all emotion and market timing from a portfolio.

Here's how dollar-cost averaging works. Let's say you buy $500 worth of McDonald's stock every month in a dollar-cost averaging program. The first month, the stock trades for $50 per share. You invest $500 to buy 10 shares of McDonald's. The next month, McDonald's trades for $40 per share. Your $500 monthly investment now buys 12.5 shares of McDonald's. (You can buy fractional shares of stock if you employ dollar-cost averaging in a company's dividend reinvestment plan.). In month 3, McDonald's jumps to $48 per share. Your $500 investment buys 10.4 shares. In month 4, McDonald's returns to the $50 level, whereby your $500 investment buys 10 shares of stock. At the end of four months, you've invested $2,000 to buy 42.9 shares, giving yourself an average cost of $46.63 per share. Yet McDonald's is trading at the same $50 price it was four months ago. The fact that you bought more shares when the stock dipped is the reason you are sitting with a profit on your investment even though McDonald's has registered no net gain in stock price in the four-month period.

Of course, dollar-cost averaging in a stock that goes from $40 to $4 and never rebounds can be devastating to a portfolio. Focus any dollar-cost averaging strategy on stocks that have outstanding finances, solid track records of dividend and earnings growth, and industry-leading positions. Avoid dollar-cost averaging with penny stocks and other high-risk stocks.