No one wants to pay too much for stocks. But with the market climbing these days, how do you avoid that? Remedy: Use what’s called dollar cost averaging, buying a constant dollar amount of stocks on a continuous schedule, in bad markets and good.
Plenty of investment commentators discourage folks from investing in the U.S. stock market lately. They note that the Dow Jones Industrial Average, an index that measures values of 30 stocks chosen to represent the general economy’s health (see chart below), is over 14,000 for the past month. The Dow in March passed its 2007 record, and generally positive economic data are keeping prices elevated.
The naysayers’ conclusion is that it’s folly to invest your money in stocks since the market had a zero return over the past five years. Other indexes measuring the U.S. stock markets, such as the Standard & Poor’s 500, also returned nothing (excepting dividends) since the financial crisis. So avoiding stocks seems intuitive.
Whether stocks are high or low, you are cheating yourself if you don’t invest in them. They are the only likely way to find a return high enough to truly build wealth for retirement. But how can you take advantage of both up and down markets?
Over the past five years, we advised our clients to continue buying stocks or mutual funds every month. This strategy is called dollar cost averaging. By using this strategy consistently, instead of trying to time the market, you buy the same dollar value of a stock or mutual fund that you have confidence in every month. If the price drops to $50 from $100, it’s a bargain. You buy twice as many shares as last month.
When the market eventually turns around, your portfolio carries stocks with a lower cost overall. The chart below compares the amount an investor saves stashing his investment in cash (under the mattress or in a money market, paying virtually zero yield) to the value of the portfolio invested in diversified stocks, such as mutual funds. It assumes the investor regularly invests $1,000 per month over the 64-month period (approximately five years) beginning in October 2007, the previous market peak, and ending in February 2013, with dividends reinvested. The data are based on closing prices of SPDR Dow Jones Industrial Average (DIA), an exchange-traded fund that tracks the 30 Dow stocks.
Rather than ending the five years with a static $64,000 ($1,000 per month for 64 months), the investor using dollar cost averaging ends up with $88,500, or 35% more than a static analysis suggests. This works out to a return of approximately 7% per year, rather than a zero return that the market’s round trip would suggest.
Dollar cost averaging also offsets some of the risk of investing in stocks in the long term. Since 1900, there were four 10-year periods and four 20-year periods when stock returns were virtually nil.
That means that if you invested a lump sum in the beginning, you made nothing after 10 or 20 years. We remember the “lost decade” of 2000-2009. After 10 years and two recessions, the country’s gross domestic product, household wealth and stock market stayed essentially still. If you bought at the top of the bubble in 2000 and held, you gained almost nothing.
But if you just gradually invested the same amount each month, you bought some at the top, some at the bottom and watched your investment grow considerably. No need to get frustrated trying to time the market or losing sleep worried that you bought overvalued shares.
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Bert Whitehead, MBA, JD, is a fee-only financial planner in Franklin, Mich. He regularly blogs at www.bertwhitehead.com and on FiGuide. Bert is a founding member of the National Association of Financial Planners (NAPFA) and the Alliance of Cambridge Advisors (ACA).
He wishes to thank Al Hoefer, his technical consultant, and Laura Webber, his executive assistant, for their assistance in preparing these charts and proofreading this document.?
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