The best defense against today's markets? Play offense, regularly
08/01/2010 - The volatile stock markets we've endured over the past few years can be a serious challenge for investors. Have you held back from the markets because of you lack confidence about their short-term direction?
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One of the most effective strategies in times like these may be to take advantage of price swings and keep putting money to work in the market. Investing a lump sum into stocks during such unpredictable times may not be particularly enticing to most of us. But making regular investments on a consistent basis over time could turn the market's volatility in your favor.
While some may think it is never good to invest when stocks are losing value, a systematic investment strategy creates the potential to turn a weak market into a profitable, long run opportunity. If you believe stocks will gain in value between now and the time you need to take your money out of the market, today's volatility might create an attractive opportunity for you.
The dollar-cost averaging approach
Dollar-cost averaging is a term that has become commonplace for many investors. It involves buying shares of an investment, such as a mutual fund, with a fixed dollar amount at regular intervals. When share prices are low, your investment purchases more shares. Over time, the average cost of your shares will usually be lower than the average price of those shares.
When share prices rise, fewer shares are purchased. This strategy is not guaranteed to result in a profit or protect against a loss. To be most effective, it requires continuous investing, regardless of fluctuating price levels. Before committing to a systematic investment program, you must consider your financial ability and willingness to continue to invest through fluctuating markets.
The big payoff from dollar-cost averaging through volatile periods can come when markets regain lost ground. If you continued to invest throughout the market's downturn, you are likely to have accumulated a larger number of shares (compared to making a lump sum investment at the start of the investment period) and could come out dollars ahead. Investors should consider their ability to continue investing through periods of low market prices.
Consider the example of an investor assessing his investment options in October 2007. This happened to be just when the stock market peaked before the major downfall that lasted until March 2009. The following example is based on a hypothetical investment in the Standard & Poor's 500 stock index, an unmanaged index of stocks. (It is not possible to invest directly in the S&P 500 or any other index. No taxes or fees are assumed.).
A lump sum of $3,000 invested at the start of October 2007 would have lost ground, declining to a value of $2,435 by the end of March 2010. That's a loss of almost 19 percent in 2-1/2 years. By contrast, the individual who decided to consistently invest the $3,000 in small bites – $100 per month for 30 months – would have seen the investment grow to a value of $3,305. That's a 10 percent increase in value for the total sum invested over the same period of time.
The difference was dollar-cost averaging, which took advantage of the market's temporary downturn to build additional shares of the investment. That paid off when the market began to recover lost ground, as it did in the last 12 months of the period in this example.
This hypothetical example demonstrates two potential benefits of dollar-cost averaging. First, it allows market downturns to potentially work in your favor and may make it easier to invest through difficult times. Second, if the market does rally, you benefit more when the environment improves, having purchased more shares in the market during different periods at varying price levels.
You may already do it at work
If you participate in a retirement savings plan at work and continue to defer income out of each paycheck into your plan, you are already making use of dollar-cost averaging. You are putting money into the market on a systematic basis. That may help insulate your retirement portfolio from the market's continued volatility and unpredictability.
Even if your retirement accounts lose ground temporarily when market corrections occur, it may make sense to continue investing through the difficult times. In many ways, maintaining a consistent investment pattern throughout the ups-and-downs of the market may be your best defense against the impact of short-term swings. If you believe that the market will, over time, maintain its long-term pattern of growth, you may be best served by using this strategy to take advantage of periodic downturns to purchase more shares with your investment dollars. Many find that this strategy makes it more realistic to keep investing money over the long run.
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