This month, I want to talk to you about a sensible, risk-reducing investing strategy that allows you to earn the premiums of a bull market, as well as the discounts of a bear market; I am talking about using a “Dollar-Cost Averaging” Strategy.
Let’s face it; last year was pretty tough for investors.
After several years of bull market gains coming off the 2009 recession, the S&P posted negative results at the close of 2015. And 2016 is lining up to deliver more of the same: high volatility and low returns.
If you expect the market to move lower, is this the moment to pull out? Not necessarily. While there are bad years, the general direction of the market over the long-term is upward. Since 1926, the stock market has appreciated an average of 11% a year. Of course, that included many bear markets, where there was a nerve-wracking decline. and bull markets, where double-digit gains were celebrated.
If your investment horizon is long-term, like saving for retirement, for example, it’s probably wise to stay the course. Otherwise, you may be sitting on the sidelines and miss out on those double-digit gains. Even the most expert financial professionals find it hard to consistently be on the right side of the market. What’s more, selling involves transaction costs and taxes on any gains. You immediately reduce your assets.
So what is the best way to react to the current market?
This is a great time to add dollar-cost averaging to your investing strategies.
Dollar-Cost averaging is a technique where you invest the same amount of money, on a regular basis, to gradually build up your stock holdings. It’s the opposite of “lump sum investing” where you save up and purchase a block of shares at whatever the market price is when you buy.
Why does it matter?
Since the price of any given stock is likely to change significantly over the course of a market cycle (which could be five, 10, or more years), dollar-cost averaging reduces your risk of investing a large amount–at what may turn out to be the wrong time (at an inflated price during a bull market, for example).
And in a bear market, when prices are down and falling, dollar-cost averaging can improve your long-term results. That’s because your set dollar amount investments will buy more shares than before, primarily because prices are lower. Over time, market prices are likely to recover and the shares you purchased at lower prices will reduce your overall cost per share.
Many people wait to get into the market, and that is a mistake. These people postpone taking the leap and when they finally decide that the time has come, they may discover that the opportunity is gone. Investing can be nerve-wracking. On the other hand, dollar-cost averaging is far less nerve-wracking than making lump sum investments. In fact, if a major bear market is just around the corner, this strategy can give you a great head start.
For the investor who wants to “save in stock”, dollar-cost averaging is the ideal way to control both risk and stress.
When you acquire shares using a dollar-cost averaging strategy, your average cost per share is likely to be even lower than the average price of the stock during the period you were investing.
How’s that? To simplify the explanation, we illustrate below with John and David who both invest $300 in Stock XYZ.
Of course, John might have bought at $6. That would have been ideal. But you pretty much need supernatural powers to predict market highs and lows.
Veteran investors attest that no one knows when the bottoms and tops will happen exactly.
There’s no mystery about John’s cost per share… because he bought all his shares at the same time at the same price. On the other hand, David bought at different prices. What’s interesting is that David’s cost per share turns out to be even lower than the average price that the share sold for during that three-month period. Someone who made a lump-sum investment at the high, would be very happy to have purchased at the average price during the period.
But as a dollar-cost averager, you do much better than the average price because you bought more shares when the price was low. David avoided the risk of buying at the wrong time and he bought for even less than the average price that the shares were selling for during his purchase timeframe.
What’s particularly attractive about dollar-cost averaging is that it helps to ensure that your average cost per share factors in both the premiums of a bull market and the discounts of a bear market, as opposed to just the premiums that investors hope for from a bull market.
How do you put a dollar-cost averaging strategy into play?
The ideal forum for dollar-cost averaging is with Dividend Reinvestment Plans (DRIPs). A DRIP is a company-sponsored plan that allows you to buy shares directly from the company that issued the shares. Because you invest directly, you don’t have to contend with brokers and their fees, making it both feasible and cost-effective to invest small dollar amounts on a regular basis.
Once enrolled in the company-sponsored plan you might set up automatic withdrawals from your checking account to invest the same amount regularly. The plan buys the number of shares (or fractions of shares) based on the amount that you invested. Many DRIPs charge no fees to do this for you! And when you can invest commission-free, dollar-cost averaging becomes even more attractive.
The idea of dollar-cost averaging is intuitively appealing and makes a lot of sense. In a steadily rising or a volatile market, you buy in at even less than the average price over time. Most appealing of all, in a falling market, the same dollar investments will purchase a larger number of shares. All in all, dollar-cost averaging can help protect you from the market volatility experts predict for the course of 2016.
If choosing which company DRIP(s) you’d like to enroll in is your next step, I always recommend checking out our list of No-Fee DRIPs first. These companies actually pay the investing fees for you once you’ve enrolled in their company-sponsored DRIP—and you can enroll with the purchase of just one share of stock in most cases. For our complete list of companies that offer a No-Fee DRIP, Click here.
Until Next Time,
P.S. The 24th Edition of the Moneypaper’s Guide to Direct Investment Plans is available now to all Weiss Education Readers, at 30% off the original price! If you want to easily find the details of any DRIP — including 52-week high/low, dividend amount, dividend paid since date, Moody’s rating, Min/Max investments allowed, shares needed to qualify, plans offering discounts, plans without investment fees, etc., click here to claim your discount. As a Weiss subscriber, you pay just $27 (free shipping included). Save 30%– but you have to act now before the discount expires.
Ms. Vita Nelson is one of the earliest proponents of Dividend Reinvestment Plans (DRIPs) and a knowledgeable authority on the operations of these plans. She provides financial information centered around DRIP investing. She is the Editor and Publisher of Moneypaper’s Guide to Direct Investment Plans, Chairman of the Board of Temper of the Times Investor Service, Inc. (a DRIP enrollment service), and co-manager of the MP 63 Fund (DRIPX).