Dollar-cost averaging is a powerful tool for average investors like you and me. Without the luxury of hours analyzing financial statements every day, time is our most valuable tool for profits. By contributing regularly and diversifying your investments, you can build a portfolio big enough to take advantage of lower prices when they come around.
Getting the best price without a crystal ball
As much as we or the pundits on the media would like to believe, none of us has a crystal ball when it comes to investing in the stock market. Good fundamental analysis can help pick stocks that will do well over the long-term, but it does not take long looking at a chart of the S&P500 to realize that prices sometimes drop over the short-term period.
If you cannot altogether avoid these market crashes then you can at least limit the pain felt when they come around. Ideas like diversification and taking some profits when stocks get expensive will go a long way to keeping your yearly statements from showing too much red. Another favorite of mine is the idea of dollar-cost averaging.
Dollar-cost averaging works like this, say you invested in shares of Apple (AAPL) at their 2012 high of $700 dollars per share. That would be terribly unfortunate as shares have dropped off a cliff since then. Further imagine that you still like the stock over the long-term but it could be years before you see any kind of return on your initial investment. In fact, from the price of $560 at the end of 2013, shares would need to rise by 15% a year over the next four just to provide you with an annualized 7% on the investment. That’s pretty tough, even for the Cupertino giant.
Diversifying your investments means that you can periodically rebalance, selling some winners and buying more of the stocks that might not have done well but are still good companies. Buying more shares of Apple now would lower your average cost to $630 and lower the needed return on the shares for a decent absolute profit.
It’s more about saving than investing
As the graphic below shows, building a portfolio of investments to reach your financial goals is just as much about saving as it is about making those stellar returns. After ten years of investing, and assuming a 6% annual return, your contributions still account for almost two-thirds of your portfolio value. You would need to earn an average 12% annual return, an unrealistic assumption and one that would involve too much risk, to have profits represent half of your portfolio at the end of the period.
In fact, it is not until a time horizon of 20 years that a 6% market return brings profits up to 50% of the total portfolio. What does this mean for the rational investor? We talked about it in the very first post of this educational series, budget a reasonable amount to invest on a regular basis and do not withdraw money until you reach your goals.
The concept of dollar-cost averaging can work in rising markets as well. Over thirty years, stocks should be almost six times more expensive than where they started, assuming a 6% annual return. By investing regularly, you dollar-cost average for the shares you own are going to be higher than when you started but well under the price you receive when you sell.
This information is particularly important now after Mr. Trump is the elected president on the USA.