Dollar-Cost Averaging: Go Discount Shopping in the Stock Market
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If you follow me on Twitter, you will find that I often cheer when the stock market falls a few hundred points. Some investors will think that I was drunk and cursing me in their minds as their investment portfolios bleed money.
But, I have investments in my portfolio too. Shouldn’t I be sulking like most other people?
No, Because that is the time when the stock market goes on sale and I buy in every time it does so – essentially, I dollar-cost average whenever a discount stock market presents itself. Obviously, I’m not the only one who lurks in the bushes. There are plenty of other prospective investors ready to pounce on a sale.
What is dollar-cost averaging?
Dollar-cost averaging is an investing technique where you invest in increments over time. You would buy more as prices drop and buy less as prices go up.
This attitude applies the same way for a trip at the supermarket. If you are confident and steadfast with a particular item, there is no doubt that you’d buy it. It just comes to how much of it you will buy – which is often determined by its cost. Once in a while, you may find a 12-pack of Coke or a box of Cheerios on sale. You know you found a deal and these goods can last quite a while, so you buy multiples of them at a discount price. But when it isn’t on sale, you’ll still buy them but much less in quantity.
If you trust your selection in a stock, ETF, or mutual fund for the long-term, you’d prefer to purchase shares with as little cost to you as possible. When the share price ringing in a profit but you feel that the company still has room to grow, you’d continue to invest in it – but less. And finally, if you feel the share price has reached its maximum potential, it may be the time to sell.
An example of dollar-cost averaging by buying shares of Company X with $10,000:
- 400 shares at $5/share
- 500 shares at $4/share
- 800 shares at $2.50/share
- 500 shares at $4/share
- 800 shares at $2.50/share
You acquired 3,000 shares of Company X at $3.333/share. A one-time purchase of Company X at $5/share would have resulted in only 2,000 shares (1,000 less).
Since you are confident in Company X’s long-term growth, the current price only dictates the rate at which you can accumulate shares. If you figure Company X’s value to be $6/share and the business has no major negative changes to its operations, then you’d probably expect the share price to reach that level sometime in the future. Any price you pay under $6/share is considered a discount.
The Arguments Against It
The biggest factor to employ this technique successfully is the ability to shun emotion from investing. Watching my stock portfolio drop and in the red is not a pleasant site. As a human being we all feel fear when we lose something, especially money.
I conquered my fear of investing by educating myself and learning that a stock market slump isn’t a bad thing. Nevertheless, it’s not surprising that an investor doesn’t want to continue buying a stock that went from $50 to $10.
Dollar-cost averaging will never beat the guy who can time a stock’s trend. An investor who does make that one-time purchase at or near the bottom will make much more money. This person could be someone who did his homework or is plain old lucky. This person also saves on trading fees while making the most out of dividend payouts (if any). But, are you or can you be this person?
Who Should Dollar-Cost Average?
This method of investing is ideal for anyone who is incapable of, or doesn’t want to try, timing the stock market.
Mutual fund and index fund investors can dollar-cost average with less work since their funds’ performance is often based on a large, diversified selection of stocks. If the general belief is that the stock market or specific industry is bound to go up, investors simply have to follow market or industry news. When financial advisors tell clients to rebalance their portfolio by selling the funds that made money and buy more of the funds that lost money, it is essentially dollar-cost averaging.
Investors in individual stocks would have to remain informed on a company’s activity to make sure that there isn’t loss in value. And if there is, the investor’s dollar-cost averaging may not yield profitable results as expected. The entire stock market breathes more confidence in investors versus a single stock. But, individuals stocks have more growth potential.
(Photo credit: mvhargan)
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