We are all human here, right? And one thing you can always count on with humans is that we are emotional beings. We experience fear, pride, lust, greed and everything in between.
What the heck am I talking about? I’m talking about investment strategy!
Investing is one of those financial musts to get ahead yet it stirs just about every emotion humans are capable of feeling. When thinking about possible returns, you will get excited, enthused and even start to feel greedy…to think you will be able to retire fat and happy with a boatload of money! What a joy that would be. But investing also produces fear, anger and confusion because investing is difficult to understand and if you fail at it, you could lose everything.
What if there was an investment strategy that could disconnect you from the emotional side of investing and still provide results? I am talking about Dollar Cost Averaging. This investment strategy solves two of the most common problems with investing; emotion clouds judgment and the general unpredictability of the market itself.
Let’s address these issues one at a time.
Humans and our emotions
We have all seen what emotional investing can do. During the meltdown of 2008, it seemed everyone was pulling out of the market. Weathered investors were tossing fine tuned investment strategies to the wind because they stopped listening to their brains, and started thinking with their emotions.
“Be fearful when others are greedy and greedy when others are fearful” – Warren Buffet
The fact that everyone was pulling out of the market (fear) caused everyone to doubt the stability of the country. The economy took a dive and the rest is history. That is what emotional investment brings to the table. A plan is worthless if not followed through and when emotions like fear, or even greed interfere with an investment strategy, then you are better off dropping your fortune on the roulette table in Vegas.
Emotion aside, the unpredictability of the market throws a wrench into the gears.
The unpredictability of the market, and the reverse of humans
You will never be able to accurately predict the market. You may be able to guess a stock here or there but the second you make a bad guess, and lose $80,000 on that guess, you may rethink your lack of strategy.
The market will never become more predictable…so how do people make any money in the stocks?
One way is Dollar Cost Averaging
Dollar Cost Averaging is investing a set amount of money over a set period of time, regardless of what the market does. By doing this, your portfolio will average out the major ups and downs of the market to create more balance and reduce risk. The strategy works best for buy and hold investors.
I am not an investment guru but this strategy is pure logic and is one of the best ways to go for the regulars like you and me that are not only in it for the long haul, but want to avoid the stress of trading while still making money doing it.
This strategy, coupled with other investment rules of thumb such as having a diversified portfolio, can ease you into the market and mitigate much of the risk of going at it without a strategy at all.
Let me give you two scenarios to illustrate the strategy.
Scenario A: Timing the market
You have $1000 set aside each month to invest in the stock market. You watch the market and do your research. You pick a company that you want to buy and it looks like a sound choice. They have a good running history and look to be doing well, but seem undervalued. Great. The next step is to actually put that money into action and buy stock in that company. You continue to hold off, watching the companies ticker for that big dip when you will get in, but the stock continues to rise. You start to feel like you are missing out on the opportunity. You get nervous and your emotions start to take over. Time is ticking and you decide to just go for it. The stock is nearing it’s 52 week historic high but you don’t want to miss out on gains as it continues to rise! You go for it…pumping that $1000 you set aside for the past few months into this golden goose. To your dismay, in the following days, your company announces a change in direction into within the company, and the stock price begins to decline!
“It’s ok”, you tell yourself as you watch the little red ticker sink lower and lower each day. “The company will turn things around. The public will eventually take a liking to what the company is doing now and the stock will start to go back up…right?” You wait, and watch. Fear takes hold again and you can’t stand to see any more of your money lost on this poor choice…on this failure…so you sell…
Well, just like you said, the public took notice of the companies new direction and the stock started to gain value again. The stock went back up, even higher than when you bought it. Not only did you lose potential gain, you lost your investment money by selling at the bottom.
Scenario B: Dollar Cost Averaging
You have that same $1000. You decide you aren’t “that guy” that has all the luck, so you set up an automatic investment strategy. Your $1000 will be invested into the company of your choice, at $250 chunks each week. You will leave that account alone and let it do it’s thing, checking it periodically out of curiosity. You insist to yourself that you won’t meddle with the plan you have put in place. You will let that account continue to invest automatically, every week, for the next year then review your progress.
You continue to watch the stock ticker of the company you have chosen but you swore to let it ride. Each week, with the shifts in the market, your company stock shifts. One week it was way up, the next it dropped a little, and the next it was well below the 52 week low.
At the end of the year, you review your progress. After checking the general standing of the account, which is overall very positive, you investigate how this happened, with all the ups and downs of the market.
With Scenario A, you lost money, were an emotional wreck, and developed an ulcer from the stress. Your emotions took over while trying to time the market and you ended up with a big loss.
With Scenario B, you gained a profit, were able to relax and watch your money grow and emotion had nothing to do with it. Sure, you felt a bit stressed when the market went down. We all do! But you had a strategy, stuck to it, and in the end came out golden.
Here’s why it works
There are a couple things you need to understand about Dollar Cost Averaging. First, because you set this up and let the computers take over, you aren’t actually “pulling the trigger” on any decisions. This puts emotions in the back seat and distances you from the actual process. That’s a good thing.
Second, because the plan is a long term strategy and doesn’t rely on the market itself when making decisions, you aren’t timing the market at all and the volatility of the market will have much less effect on your portfolio’s overall gains.
And third, why you will profit from this strategy is because while your money is being invested automatically at set intervals, the stock price is changing. But you have a set amount to be invested so when the stock price is higher, you will buy less shares; when the stock price is lower, you will end up with more shares. Getting more shares at a lower price and less at a higher gives your portfolio more opportunity for that stock to climb when it’s low and won’t allow you to buy a large amount when it’s high so your potential for a huge fall is limited.
As long as the company stock gains overall for the period of time you are investing in it, regardless of the market ups and downs, you will generally come out with a profit.
A great way to dollar cost average stock purchases is with ShareBuilder’s automatic investing. Check it out!
What do you think of dollar cost averaging?
Jesse Michelsen, who writes at Personal Finance Firewall, is a regular guy with a family. He has a modest stock portfolio and does what he can to reduce risk while still planning out his retirement. This is his interpretation of Dollar Cost Averaging and why it works but it is also opinionated. Disclosure: Investing comes with risk. This blog, nor this author, can be held responsible for investment loss. Do your research before investing!