Dollar Cost Averaging
The Dynamic Wealth Report
March 10, 2008
Investing $1,000 At A Time
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.
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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.
• Oil Equipment & Services (Up 11%)
The Oil Equipment & Services industry has risen more than 11% in the
last month alone. Driving this move is the continued strength in crude
oil prices. Oil is now above $107 per barrel.
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