You are more likely to be a successful investor over the long haul if your investing decisions and actions flow from specific, predetermined guidelines. An old saying offers good advice: “Plan your work and work your plan.” We would add: “…regardless of the news of the day or the speculations of market prognosticators.”
Although guidelines for choosing specific funds are inherent in all of SMI’s strategies, two questions remain: How often should you invest? And how much should you invest at a time? A simple way to make these decisions is to use a “formula” approach—i.e., one that eliminates inconsistency and guesswork.
The best-known formula for answering the how much/how often questions is called dollar-cost-averaging (DCA). It’s neither complicated nor time-consuming. Here’s all you do: (1) invest the same amount of money (2) at regular time intervals. The amount and frequency are up to you. The important thing is to pick an amount you can stick with faithfully over many years.
The beauty of DCA is that it frees you from worrying about whether you’re buying stocks at the “wrong” time. Because your dollar amount remains constant, you’ll be getting more shares for your money when stock prices fall and fewer shares when prices rise. In effect, you’ll buy more at bargain prices and less at what might be considered high prices. (Of course, only when you look back years from now will you know when prices were truly bargains and when they were too high.)
For DCA to work, however, it is critically important that you ignore all market fluctuations. Most investors who end up with poor returns are victims of their own emotions. Only after stock prices have been rising sharply do they work up enough courage to buy. Then, when prices plunge, they become fearful and sell. The consequence is that they “buy high and sell low,” the very opposite of their intention.
It is important, therefore, not to let your emotions control you. If you’re going to use dollar-cost averaging, you must exercise the discipline of maintaining your systematic investment program.
Cautions and critics
Understand that dollar-cost averaging isn’t a cure-all. For one thing, it doesn’t protect you against losses. While DCA does result in your average cost per share being lower than the average price of the shares over time, in a bear market you can still suffer temporary setbacks. Furthermore, DCA can lower your potential profits. Let’s say you invested every month in a mutual fund in which the share price rose steadily all year long. In that case, you would have enjoyed greater gains if you had made a single large investment early on, rather than making investments over time.
Indeed, because the market has a long-term upward bias (i.e., it has always moved higher eventually), some analysts argue that DCA is a bad idea if investing sooner is an option. They note that you’ll pay more for shares (on average) if you stretch out your buying than if you invest as much as you can as soon as possible.
That’s all well and good when you’re looking back over a 40-year period with the confidence that comes from 20/20 hindsight! But it ignores bear-market periods along the way that can frighten investors out of the market altogether. For example, if you invest your $50,000 inheritance just before a bear market wipes out $10,000 of it, will you have the stomach to stay around and wait for the next bull market to recoup your losses and move you into the black? Perhaps, perhaps not. So the academics have it right in theory, but in the real world DCA makes it much easier for investors to overcome their fears and make the difficult decision to put their savings at risk.
Reasons to like DCA
In summary, dollar-cost averaging is the systematic investing of a fixed amount of money on a regular basis, usually monthly. DCA has these benefits:
- It eliminates the need to ask, “Is this a good time to buy stocks?” As far as DCA investors are concerned, every month is a good time to invest.
- It imposes a discipline—a structure for making “installment payments” on your future financial security.
- It causes you to buy relatively more fund shares when prices are low and fewer shares when prices are high.
- It helps you “automate” your investing, thus eliminating the risk that you’ll forget or be distracted by the market news of the day.
Dollar-cost-averaging can be especially helpful in conjunction with no-load funds because such funds allow the purchase of fractional shares, eliminate commission costs, and offer sufficient diversification to reflect the stock market at large. DCA is also an excellent technique to use with 401(k) and 403(b) retirement-plan investing.
There’s no single “right” way to employ DCA—the timing and the amount are entirely up to you. Just be careful that you don’t overcomplicate an uncomplicated system.
Regardless of the particulars of how you choose to implement dollar-cost averaging, consistency is the key. Keep in mind Proverbs 21:5, “Steady plodding brings prosperity” (TLB).
Next month we’ll look in-depth at how DCA utilizes corrections and bear markets to actually improve your long-term rate of return.