The sell off which began in earnest in 2008 and continued through the beginning of 2009 panicked many individuals to the point where they took money out of the financial markets and placed it in the relative comfort of the cash market. The decade prior was a period of near record low saving rates by individuals coupled with a consumer who highly leveraged their personal balance sheets. Add on the recent prolonged recessionary period, high unemployment rates, and the eventual reversal of the flamboyant consumer spending habits; and the net result has created a scenario where many investors are flush with cash that is sitting in money market accounts earning historically low interest rates.
As we pass the half way point of 2010 and the economy strives to regain its footing, recover from the recession, and expand; there are signs that investors are looking to leave the relative safety of the cash for the risk and potential higher returns of the stock market.
The natural question that pops into most investors’ minds as they begin to explore moving the cash back to the financial markets is when exactly is the right time to begin? Should investors’ wait for another market downturn, a type of buying investments “on sale”? Should investors’ invest as soon as possible so as not to miss the next possible market boom?
If interested in achieving long-term growth of capital, a seasoned financial advisor might recommend a strategy known as “dollar cost averaging” because as too many investors have discovered, and undisciplined approach to investing can make portfolios overly sensitive to shifts in market value.
The idea behind dollar cost averaging, as an alternative to lump-sum investing, is simple. Instead of trying to time market highs and lows, the investor regularly, continuously, and systematically invests a reasonable amount of money in an investment vehicle over a longer period of time. The investor looks to take advantage of market fluctuations over time to reduce the average share price they pay for the security.
Such a strategy attempts to take market ups and downs out of consideration and turns them to your advantage through discipline. Since the focus of dollar cost averaging is on long-term results, investors should not be overly concerned with whether prevailing market conditions are strong or weak when they begin to invest. What matters, instead, is that they choose a realistic dollar cost averaging program based on their individual financial situation, begin that program and stick with it.
To illustrate how dollar cost averaging might work as an advantage, let’s assume that an investor decides to invest $1000 in a mutual fund every three months. If shares in that mutual fund sell for $10, and no additional charges are involved, the first quarterly investment would purchase one hundred shares. Should the market then fall dramatically, reducing the value of fund shares to $5, the $1000 second quarterly investment would purchase 200 shares. If the market were to rebound and fund shares were to rise to $10 in the third quarter, the next investment would again purchase 100 shares, valued at $10 a piece.
Where would the investor stand after making the purchases outlined above? He would, of course, own 400 shares, purchased for a total investment of $3000, with an ending market price of $10 per mutual fund share. However, the shares would actually be worth more than was paid for them. The total current value is $4000 even though the purchase price was $3000.
If this strategy is viewed from another perspective, you can see that the average cost per mutual fund share of the three quarters involved ($10 plus $5 plus $10, divided by three) would be $8.33. The average cost to the investor, however, would have been only $7.50 ($3000 divided by 400 shares).
Every investor wants, in the words of the market adage, to “buy low and sell high.” Lump sum investors (ones who purchase an investment all at once or over a short period of time, usually a matter of weeks) try to time their security purchases and sales in an effort to do just that. When successful, they may realize greater profits in a rising market than investors following a dollar-cost averaging strategy.
However, lump-sum investing versus periodic investing isn’t that clear cut. The problem for any investor, but particularly a lump-sum investor, is always that of knowing when to buy and when to sell, of properly timing his or her investment decisions. The market is not entirely predictable; if a lump-sum investor buys high and sells low, he or she will suffer a loss. While a dollar cost averaging investor might also suffer a loss in a declining market, the loss may be less severe than that of his or her lump-sum investor counterpart.
Because a dollar cost averaging investment strategy buys more share of a security as the price of the security declines, this strategy does offer some downside protection in a declining market. What’s more, as the market rebounds, a dollar cost averaging investor will “break even” (or realize a gain) more quickly than his or her lump-sum investor counterpart. That’s because the dollar averaging investor owns more shares (at a lower cost per share) than does the lump-sum investor.
The ability to stick with the original investment plan regardless of changes in prevailing market conditions is the key to success in dollar cost averaging, and investors should consider their ability to continue investing during periods of low prices. Of course, a profit is not guaranteed and dollar cost averaging will not protect against a loss in declining markets. However, following a dollar cost averaging plan of action may help avoid getting out of the market when it’s low and rushing in when it’s high. Be sure to check with your financial advisor whether dollar cost averaging can help give you a discipline for success in the financial markets. The bottom line is if you have cash that you are looking to put back to work in the financial markets, whether you believe we are headed for a double dip recession, a prolonged side way movement of the economy, or a slow and steady climb, then this strategy may be a good way to put your excess cash back to work in the financial markets.
If you have any questions pertaining to this article, please contact Steven D. Brett at 631-414-4020 or by e-mail at [email protected].