Want to outsmart the bear? Stick to dollar-cost averaging
History has shown that dollar-cost averaging as an investment strategy in shares - particularly during bear markets - results in portfolios that are worth more. How? Well, there are a couple of tips you need to follow.
At an initial glance, it might seem odd that continuing to invest in stocks during a bear market can actually create a portfolio that is worth more long term.
But that’s exactly what history and research show.
What is dollar-cost averaging?
Dollar-cost averaging means investing a fixed-dollar amount, regularly (say monthly), in a particular investment or portfolio - regardless of its share price and regardless of market movements.
By doing this, you buy more shares when prices are low, and, conversely, fewer shares when prices are high. This moderates your portfolio’s volatility over time by minimising your exposure to the risk of investing large sums in a single purchase. (One risk being that you make a large investment in an asset just before its value suddenly drops.)
What about a hiatus when prices wobble?
Dollar-cost averaging is a long-term strategy, and this is where people can fall off the track.
In bear markets, when most of the talk is doom and gloom, it can be hard to remember that trying to “time” the market doesn’t work. People might try to time the market by jumping ship just before prices drop and then get back in again before they rise.
The problem with timing the market is that it is impossible.
Jumping ship before prices drop inevitably means “before they drop too much”; what’s too much? Or, out the other end, trying to get back in at “just the right time”; who knows whether they’ll be cheaper or more expensive tomorrow?
In fact historically, investors tend to put more money into shares after the market has already begun to rise. (See article “Self sabotage on investments is just a thought away” in Autumn 2009’s newsletter.)
In a bear market, fear as to where it’s headed causes many people to stop buying shares.
Fear is emotion. And it’s never a sound strategy to let your investments be guided by emotion. (Again, see the article named above.)
But why keep investing in a bear market?
Quite simply because in the long term – and that’s what most investment on the stock market is - your portfolio will be worth more.
Let’s take an example, and look at an investor who sticks to their strategy and those who don’t.
Those who deviate from their plans will no doubt do so at different times, being influenced by different factors (emotion, what their friends are doing, what their cousin’s friend’s broker said, and so on).
One might stop investing in shares and move to cash when the market drops 20%, while a second might do so at the bear market’s cyclical low point. Let’s say both start investing in shares again as the market resumes a long-term up. The first one, who withheld investments in shares after seeing a bear-market signal has average-to-poor timing; but the latter one, who threw their hands in the air, has shocking timing.
On the assumption that each starts with $10,000 of shares, and is investing $500 a month before the bear market strikes, what’s the effect?
The following figures are based on the 2000-02 bear market (the last of a high ferocity in the US), and assume those who stopped investing began buying again in January 2004 (a date based on historical analysis of how long it typically takes investors to feel comfortable buying stocks again after a bear market).
Post-bear market (Jan ‘04):
* the investor who stuck to their strategy has $33,502
* the 20%-drop stopper has $31,799
* the hands-in-the-air stopper has $31,616
But, the stock market is a long-term investment, so the big test is where will they be in 30 years?
* the investor who stuck to their strategy has $617,331
* the 20%-drop stopper has $585,951
* the hands-in-the-air stopper has $582,579
Even if a 4th investor miraculously timed the market and shifted to cash before the bear struck (and began again at the same Jan ‘04 mark), they would still be $2,671 worse off after 30 years. Now while that doesn’t sound like much, it completely relies upon a crystal ball to time the market. And who has one of those?
Better buying power
The investor who stuck to their dollar-cost averaging strategy has bought more shares at lower prices through the equity downturn, so has reaped bigger portfolio gains as the market recovered.
Those investors who shifted to cash investments as the market declined, didn’t benefit from buying shares when they really were “on sale”.
Research also shows that dollar-cost averaging investors who deviate from the strategy - trying to time the market’s downturns - will probably do it again next time the markets dip. This, of course, will only have one effect on their portfolio: to further inhibit its long-term value.
Conclusion
Dollar-cost averaging highlights the investment mantra of “be consistent”. If it’s in your plan, then deviating from it weakens the power of compounding in your portfolio value.
Naturally it’s impossible to predict when the current global financial crisis and its consequent weight on the stock market will subside. But the examples above show you that those investors following a dollar-cost averaging strategy will probably benefit the most when the market resumes its long-term upward trend.
And if nothing else, they’ll remind you there is light at the end of the tunnel if you’re feeling completely squashed by the world’s challenging economic events.
Although dollar cost averaging is a useful strategy during bear markets, it is not always the right strategy to use, and an investor needs to take into account the current market position (dollar cost averaging can detract from returns during a rising market) and an investor’s comfort level with the sharemarket in general.
Sources: “Dollar-cost averaging: The bear market solution investment strategy?”, from Fidelity; Wikipedia; “It’s still a good time to use the dollar-cost-averaging strategy”, by Robert Stepleman, Herald Tribune.