Dollar Cost Averaging

| March 10, 2008 | 0 Comments

I was talking with a good friend about his investing strategies over the weekend.  He got lucky and managed to exit the market at just the right point a few months back and now is sitting on some cash.  He’s thinking now might be a great time to buy into the market.  Despite a long term investment horizon – more than 10 years – he’s scared. (I’ll get to his fears in a minute.)

Sidestepping the markets.

The first thing that impressed me was his ability to sidestep a huge market downfall.  More than a year ago he had noticed the problems in the real estate market, and how it was impacting banks.  A huge portion of his portfolio was invested in Citigroup (C).  He was smart, he had an exit strategy for this investment.

Watching the stock closely over the next few weeks, he sold everything when it pulled back 10% from the high.  Booking a small profit on the transaction, he more importantly sidestepped a huge loss.  By my rough calculations, he avoided losing more than 60%!  His sell discipline in essence saved his portfolio.

What now?

Lately, the markets have been bouncing around.  He wants his next investment to be a long term one.  The money is set aside for his 2 young daughters to go to college.  This gives him more than 10 years before he needs the money.

Despite his solid track record investing, he keeps second guessing himself.  Every week he thinks now is the time to invest, but for some reason he doesn’t pull the trigger.

That’s when we started talking.

He has two big fears.  The first is buying in and then watching the markets head lower.  The second is watching the markets head higher while he is sitting on the sidelines.

Both fears are real.

Can the markets head lower?  Sure they can.  Personally I think we will be heading lower in the markets for at least the next several weeks – if not months.  Just a few weeks ago, I hedged part of my portfolio by buying puts on the NASDAQ (I’m doing really well in those).  But my friend is right.  At some point the market will turn.

Here’s the problem.  When the market does turn, the move could be dramatic and you could miss it (studies have shown that missing just a few important “up” days a year significantly reduces returns over the long haul).  So, if you’re sitting on the sidelines you get no benefit from the move, and you might not notice the move happening.

What’s the solution?

In my opinion, the best way to solve both of these problems is through dollar cost averaging.  If you don’t know what it is, don’t be surprised, most investors don’t.  It’s a great way to reduce the fear we all feel as investors.  You can limit your downside exposure (if the market drops) and still participate in the upside (when the market rallies).

Here’s how it works.  You take the money you are going to invest and break it into smaller investments of equal size.  At set time periods, normally a few weeks or a month, you invest that money into the market.  You set it up so it’s automatic.  No confusion, no second guessing.

Here’s an example.  Let’s say you have $10,000 you want to invest.  You decide to break that investment into 10 parts and invest once per month for the next 10 months.  Your first investment of $1,000 is in March. Then in April you invest another $1,000.  You do it again and again over the next 10 months.

Why would we do this?

What you’re doing is averaging out the price you pay for an investment. Some months you buy at the lows (if the market drops).  Other months you will buy at the highs (when the market rallies).  No need to try to pick the market bottom or miss a big move up.

Many investors are using this very strategy and they don’t even realize it.  If you invest though a retirement program at work they do the same thing.  Every pay period you have money deducted from your paycheck and put into an investment account.  That investment might be at new lows or new highs.  Either way, it is being added to your portfolio and averaging out the price you pay for the investment.

One last important point about dollar cost averaging- it’s a long-term strategy.  It won’t work very well if your investment timeline is short. With that said, if you’re looking to get the outstanding long term benefits of stocks, dollar cost averaging can be a very effective strategy.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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