It seems like only yesterday that I was writing to you about my daughter Vela’s first birthday … and using the occasion to make the case that dollar-cost averaging was a terrific way to approach the stock market.
Of course, it wasn’t yesterday. In fact, this weekend my little girl will be turning four! And while the party is certainly going to be a lot of fun, it’s bittersweet because it’s yet another reminder of just how quickly time passes by.
Meanwhile, we have seen quite a wild ride in the markets just over Vela’s relatively short lifetime, too.
That’s why I want to spend a little time revisiting that strategy of dollar-cost averaging — to see if we can still safely call it one of the most boringly profitable investment approaches available … one that puts the passage of time to work for us rather than against us.
Dollar-Cost Averaging:
Cruise Control for Your Portfolio
The idea with dollar-cost averaging is relatively simple: You buy equal dollar amounts of the same investment on a predetermined schedule.
Please note the italics in that last sentence. Dollar-cost averaging IS NOT buying a fixed number of shares on a regular basis. In fact, it is quite the opposite. Here’s why …
Let’s say you’ve decided to invest $10,000 in XYZ Corp. Rather than deploying the entire amount at one time, you might instead opt to purchase $1,000 of XYZ stock on the first day of each of the next 10 months.
What’s the logic behind this approach? Well, you can expect just about any stock’s price to vary substantially over a ten-month period. So, when the price is higher, your $1,000 will buy fewer shares; when the price dips, your $1,000 will buy more shares.
In other words, buying equal dollar amounts over time allows you to reduce your risk to a stock’s short-term price movements, automatically encouraging you to buy more when prices are lower and less when prices are higher.
It also removes much of the emotion from the investing process. You’ve already committed to buying the stock at regular intervals, regardless of market conditions.
And because you’re doing this automatically, it doesn’t require more than a few minutes of your time (if any at all!).
Okay, But How Does This Strategy
Fare When the Road Gets Bumpy?
Obviously, buying bits of stock as the market continually rises would work just fine … even if it meant you missed out on some additional upside by not putting as much in as quickly as possible.
But what about the other scenario — the one where the market really zigs and zags, moves sideways, or even goes lower over a long period of time?
Well, again, there is perhaps no better example of this kind of action than the last few years!
Just take a look at a chart of the S&P 500 since June 12, 2007 — the day my daughter was born …
As you can see, despite the huge declines and rallies, the broad U.S. stock market index is still lower than it was four years ago.
And yes, if you’d had very good timing, you could have clearly been making a fortune during every one of those major moves … but what if you didn’t have perfect timing? Or if you had BAD timing?
That’s where dollar-cost averaging comes in. Let’s look at what would have happened if you simply followed this approach over the last four years — investing an equal amount of money in the S&P 500 ETF (SPY) at the beginning of every single month.
It’s a long table, but I want to show you exactly how this works …
As you can see, by putting $1,000 into a broad-based ETF each and every month over the last four years, you would have spent $49,000 to buy a total of 441 shares.
Based on the SPY’s recent price of 131.73, that total stake would currently be worth $58,144 — a total profit of $9,144!
That’s an 18.66 percent return over the four years … even though the market actually FELL over the same time period!
The reason, as I mentioned earlier, is simple: While you would have bought some shares when the market was at its peak, you also would have forced yourself to buy a bunch of shares when the market was much lower than it is today.
Now, does this mean that careful timing or superior stock selection couldn’t have given you even BETTER returns?
No way!
But in the case of buying individual stocks, it’s worth noting that you can apply dollar-cost averaging there just as easily as you can with broad-based ETFs.
In addition, you are also using this same general concept whenever you reinvest your dividend payments or make regular contributions to the same funds in a retirement plan such as a 401(k).
Of course, whether or not you decide to put dollar-cost averaging to work in your portfolio, the important part is remembering that while time often passes more quickly than we might like, the key to success — in both investing and life — is finding a way to capture those key moments that happen along the way.
Best wishes,
Nilus
{ 6 comments }
A while back in your dads portfolio you recomended a buy for VZ. You failed to make the price but I did. Now I am sitting on a 37% profit and I am wondering if I should stay with it or sell. I noticed that you tend to recomend a sale when profits reach this level. as with XOM and NGG. Would you please comment on this in your next question and answer portion of your newletter.
Thank you
Bob Terhune
In response to Bob, you might try a trailing stop. I don’t remember exactly, but I’m assuming VZ pays a dividend (since everything in his dad’s portfolio does) so you collect income for holding it, and collect more income if it goes up. The only way you lose money is if it crashes.
So if you can put in a trailing stop then you can keep holding VZ unless it goes down substantially. I’d probably use 15% (but there’s no good reason for that, you could just as easily choose 10% or 20%). That gives room for volatility so you can keep holding it and collecting the income. If VZ goes up your stop goes up too. If the markets do crash you still make at least 20% on the stock from what you bought it at.
If you can’t do a trailing stop, then you could just use a regular stop-loss and move it up manually if the price of VZ continues to rise.
I’m also curious what Nilus Mattive recommends to do though, since he’s better at this than I am.
-Brandon Caesar
Question: In your comments on covered options you used the example of selling a covered call option on a stock that you bought for $30. You set the strike price for $35 at a future date. Why would someone buy the option for the right to buy it for $35 when they could just simply buy it if it reaches the $35 price. Perhaps I am misunderstanding your comments.
thank you
Pat
Nilus,
Re: dollar-cost averaging.
You forgot to consider the buying commission in your example.
Frank
To add to dollar cost averaging,one’s average cost per unit is always less than average purchase price
Nilus,
18.6% return sounds nice on the surface but thats over an entire 4 yr. period.
The actual return is only 4.65% per year which is unacceptable to most investors including myself.
Please comment.
Thank you.