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Why Dollar Cost Averaging Can Be Your Best Friend

By:   |   Jul 08, 2018   |   Views: 14   |   Comments: 0

By Larry Lane for www.InvestorZoo.com

In the investment world, there are many types of risk. Volatility will cause your investments to rise and fall in value. How you manage volatility and risk will determine whether you will be an investment winner or loser.

What is the Risk?                  

Before investing in a stock, mutual fund or ETF, there are several factors to consider. How would you react if your investment went down 25% in 6 months? What about if you suffered a 50% loss? Not a pleasant thought, but these are the unfortunate realities of investing. There is no free lunch and no perfect investment strategy. Investors in Long Term Capital Management will attest to this. LTC was initially successful with annualized returns of over 40% (after fees) in its first couple of years of operation. However in 1998, LTC lost $4.6 billion in less than four months when Russia defaulted on its loans. Long Term Capital consisted of John Meriweather, the former vice-chairman and head of bond trading at Salomon Brothers. Board of director members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Prize in Economics. The most brilliant economic minds failed because they didn't properly plan for the risk that the market presents. Yes, even a country defaulting on its sovereign debt can occur.

Investing Can be Scary

Historically, the stock market has experienced a drop of 10% every year and half. On average, you will see a 20% loss every 2.5 years and a 30% drubbing every four years according to InvesTech Research. Would you like more good news? In 2002, T. Rowe Price, a mutual fund company completed a rather surprising study:

1) There is a 27% chance you will lose money if you have one year to invest
2) There is a 14% chance you will lose money if you have 3 years to invest
3) There is a 10% chance you will lose money if you have 5 years to invest
4) There is a 4% chance you will lose money if you have 10 years to invest

In short, the stock market can be a scary place to invest. Ask yourself "what would happen if this part of my portfolio went to 0?" Are you overly allocated in one sector or stock? Have you been at the same company, investing money for the last 20 years in your company's stock? Does this now make up 20-50% or more of your portfolio? The employees of Bear Sterns, Lehman Brothers and others who are improperly allocated will feel the sting of this recession/depression for years and possibly decades to come. The prospect of coming back from a 50% loss will mean your investment must double just to break even.

For most investors who are not pouring over charts, reading over 10k reports and glued to their television 24 hours a day watching CNBC for breaking earnings reports, diversification is paramount.

No Free Lunch          

No investment is 100% risk free. The economy, interest rates, wars, terrorism and a myriad of other factors will affect your investments. The key to successful investing for most is staying invested long term and being properly allocated. Invest all your money in internet stocks and you would have seen a huge drawdown in your portfolio in 2000. Stay "conservative" in bonds and you'll lose significantly when interest rates go up. Want to invest in commodities? Oil went from $147 to $40 in a heartbeat in 2008. If you had too much money invested in oil, you may have done something very foolish along the way like sell at the absolute low and the absolute worst time. If you had just 5% invested in oil or better yet a basket of commodities (this can be purchased via an ETF or mutual fund), you probably slept pretty well.

A good financial advisor will not recommend a stock or investment to a client because he got a hot tip or because it "feels right". A financial advisor will probably not find you the next Google, but will construct a complete portfolio consisting of assets from many investment classes.

For every successful full time day trader, there are dozens or 100s that have blown their account up and now have nothing. There are simply too many variables to consider. There is slippage (the spread between the bid and ask price), commissions and oh yes, you have to be correct more than 50% of the time using correct money management skills. Invest long term and properly diversify your portfolio and you can be wrong, dead wrong a lot. In fact by dollar cost averaging you can wrong for years and come out ahead when the market finally recovers.

For the example, assume you put in $100 per month into Fund X:

Month$ Amount Invested Share Price Shares Purchased
1          $100                               $50                      2
2            100                                 75                      1.33
3            100                               100                      1
4            100                                66.66                  1.5
5            100                                40                        2.5
6            100                                25                        4                                                   7            100                                33.33                   3
8            100                                66.66                   1.5
9            100                                80                         1.25
10          100                                80                         1.25
 

Total $1,000 19.41 Shares Purchased Average price per share is $51.52
Dollar cost Average/Monthly Investing = Cost of shares divided by the number of shares purchased ( $1,000/19.41= $51.52).

Despite the fact that fund X was extremely volatile, you did pretty well. Your true cost is $51.52 and the fund is now trading at $80! You've purchased more shares when they are on sale and less when they are higher. This is a good acumen of any good investor. You didn't even have to stay up late at night worrying that some financial analyst just downgraded your stock or sector.

While this is a hypothetical dollar cost scenario, hopefully the illustration above exemplifies the importance of dollar cost averaging and investing long term. If you don't have a lump sum to invest, dollar cost averaging makes investment sense for most investors.

Wrapping it Up         

In closing: Invest as if you have to go before a judge and defend your investment. Get the help of an experienced financial planner to help you though the rough patches when the market is experiencing a correction. Be consistent with your investment decisions and have a solid investment plan.

Larry Lane is the editor for www.InvestorZoo.com, a personal finance site specializing in personal finance

The article above is intended to provide information of a general nature and may not be suitable for your individual situation. Please consult a qualified licensed financial advisor before making any financial decision.

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