Put Your Portfolio on Autopilot And Ride Out the Market Turbulence!
InvestorEducation / Learning to Invest Jun 18, 2008 - 01:00 AM GMT
Nilus Mattive writes: My daughter Vela turned one last week. We had a great little island-theme party complete with grilled mahi-mahi, coconut cake, and pineapple ice cream. I'm not sure if Vela knew what the heck was going on, but the rest of us had a great time.
Of course, underneath our grass-skirt celebration was a simple, indisputable fact: Time ain't waiting around for any of us. If anything, it's flying by at a seemingly faster and faster pace.
The way I look at it, we can sit around lamenting the passage of every day or we can find ways to use time to our advantage. That's true for all aspects of life, and it's especially true when it comes to investing.
So today I want to tell you about a strategy that really puts time on your side, and allows you to kick back and relax a lot more in the process.
Even better, it's a great way to deal with the kind of bumpy markets we're seeing right now ...
Dollar Cost Averaging: Put Your Portfolio on Autopilot And Ride Out the Turbulence!
One day, it looks like the end of the world, with the Dow losing hundreds of points. The next day, investors are bidding up share prices like crazy, certain that we've seen the worst of the subprime mess.
No wonder so many people believe that taking a long-term perspective just doesn't work anymore!
I won't argue that this a great time to be a trader, especially if you're handy with options. But I disagree with the idea that frequent trading is the only way to build your portfolio in a market like this.
Contrary to popular belief, you do not need perfect timing to survive — and thrive — in markets like these. Rather, you can use a strategy known as dollar cost averaging.
Despite the name, dollar cost averaging has nothing to do with currencies at all. Instead, it refers to buying equal dollar amounts of the same investment on a predetermined schedule.
For example, let's say you've decided to invest $10,000 in XYZ Corp. Rather than deploying the entire amount at one time, you might instead opt to purchase $1,000 of XYZ stock on the first day of each of the next 10 months.
What's the logic behind this approach? Well, you can expect just about any stock's price to vary substantially over a ten-month period. So, when the price is higher, your $1,000 will buy less shares; when the price dips, your $1,000 will buy more shares.
In other words, buying equal dollar amounts over time allows you to reduce your risk to a stock's short-term price movements, automatically encouraging you to buy more when prices are lower and less when prices are higher.
It also removes much of the emotion from the investing process. You've already committed to buying the stock at regular intervals, regardless of market conditions.
And because you're doing this automatically, it doesn't require more than a few minutes of your time (if any at all!).
Now, because stocks have historically always risen over longer timeframes, a lot of people argue that dollar-cost averaging is a waste of time if you're sitting on a big lump sum.
Certainly, there are plenty of instances when that's true. However, in really choppy markets, I think dollar cost averaging works wonders. Let me give you an example from one of the market's worst downturns ...
Dollar Cost Averaging During the Great Depression Would Have Turned a 46% Loss into a Small Profit!
It's October 29, 1929. The U.S. stock market has just crashed over the past four days. Contrarian that you are, you begin buying $10 worth of the Dow Jones index every month for the next decade. (No, they didn't have index funds in the 1930s, but let's pretend they did.)
The 1930s prove to be a horrible time for the nation and its stocks. By the end of the decade, the Dow has lost 46% of its value.
Heck, it closed October 31, 1929 at 273.5 1 and ended 1939 at 150.24!
Looks like you got burned pretty bad, eh?
Not so fast. There were plenty of times when the Dow was down even more than 46%. In fact, for most of 1932 and 1933 you were buying below 100, sometimes as low as 40 and 50! Take a look at my monthly chart of the Dow and you'll see what I mean.
End result: While the Dow lost 46% of its value over the 1930s, you would have finished with a positive return of 5%.
That's hardly a return worth celebrating, but it shows you just how well dollar cost averaging works in the most brutal markets.
And I can't help pointing out how well positioned you would have been for the market's eventual rebound.
Now, I am not saying that dollar cost averaging is perfect. There are at least two potential disadvantages that come with the strategy:
#1. You might pay more in brokerage fees because of the multiple transactions. However, in this day and age of extremely low discount broker fees, that's not quite the concern it once was. Some brokerages have even built their entire businesses around the concept of dollar cost averaging — www.sharebuilder.com is one of them.
#2. You might miss out on a substantial gain if a stock's price takes a sharp turn higher. In other words, if you're a market timer, dollar cost averaging is not for you.
Still, I think it's a sound approach for your core stock portfolio, especially when it's used consistently. It smoothes out your risk, and allows you to regularly participate in the market's rallies.
It is a perfect way for investors with limited funds to regularly put a little money to work.
And you may very well already be dollar cost averaging without even realizing it!
You see, dollar cost averaging is an inherent characteristic of most retirement plans like company 401(k)s. That's because you contribute a set amount of each paycheck to the same investments.
To a lesser extent, the same is true of dividend reinvestment plans (DRIPs) because your dividends are reinvested on what is generally a set schedule. [Editor's note: For more on DRIPs, see Nilus' article from last week .]
When you dollar cost average into dividend-paying shares (through reinvested dividends and/or new investment dollars) you are not only harnessing the power of time to smooth out volatility, but you're also setting yourself up for terrific income along the way!
Bottom line: It takes a lot of time and skill to successfully trade the kind of market we have today. So if you're looking for an easier way to build a long-term portfolio in this choppy market, I think dollar-cost averaging is a great way to go.
Best wishes,
Nilus
P.S. Looking for some undervalued stocks well suited to a dollar cost averaging strategy? Check out some of the companies I'm recommending in my Dividend Superstars newsletter ... they're perfectly suited for that purpose. If you're not yet a subscriber, sign up right now and get 12 issues for just $39 .
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