When I was in my first four-five years as a broker way back in — well, way back — I heard about a system of investing that seemed to be infallible. It was called dollar cost averaging.
It was promoted by brokers, bankers, and even a fellow named Richard Russell, a top notch newsletter writer that continues to write a newsletter to this day. (I encourage you to look him up on the internet. He is a remarkable commentator on all the markets!)
The essence of the dollar cost averaging system is the purchase of stock at fixed time intervals, using the same dollar amount for each purchase made. It is just that simple. But, simplicity is not always all it's cracked up to be. Yes, this system means that when prices are down you do purchase more shares and when the price is up you purchase fewer shares.
The idea is that over time the average price per share will go in your favor — and of course the key to all this is to be buying large companies with stable earnings histories and a broad product line that is widely used and not prone to being easily replaced (i.e. Procter & Gamble is a good example).
This system has been used for many, many years, having been first proposed by brokerage firms in the early 1900s to help build a more reliable, steady stream of purchases (read commissions) from their customer base.
From their standpoint, it seemed a good way to generate profits and it usually was relatively successful for the investor (given the caveat that good stocks were involved in the purchase program, as I stated before).
HOW IT WORKS
Here is how a typical Dollar Cost Averaging program might work.
You determine that you will invest $400 monthly into stocks as part of your retirement program (or you might decide to put $1,200 every three months into stocks — the time period and amounts are up to you. Yearly purchases are discouraged, however, as the averaging effect of Dollar Cost Averaging system is so slight as to be negligible).
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You decide that you will put $100 into each of four stocks and select Procter & Gamble, Microsoft, Citibank, and Caterpiller as the big, stable stocks for your needs (of course, you could pick four others, but this is my example, right?).
You contact a broker and open up an account and each month send your $400 to the broker. (By the way, for this system to work best, keep the commission paid to fewer than 5 percent as a top level. So, keep that in mind, also.)
PROS OF DOLLAR COST AVERAGING
Well, that's it. That's all. Yes, Dollar Cost Averaging
is quite simple and easy to operate;
takes the worry of trying to "time" the market out of the "equation";
tends to reduce volatility in any portfolio;
includes risk reduction as a real part of the system;
over time it does seem to have proven that it works "OK";
makes sure you are at least doing some investing in stocks, a practice that, over the last 40 years has proven quite a good protection against the bite of inflation.
But can anything really be just as simple as the 1-2-3 steps above and still work really well? Well, the answer to that question is really "No." But, I hasten to add, for those of you that want to keep it simple, this 1-2-3 program will make your life much more bearable if you invest, let you sleep much more soundly than those that invest on a hope and a prayer, and will work "satisfactorily" over long periods of time.
CONS OF DOLLAR COST AVERAGING
But, if put to the test, Dollar Cost Averaging will likely not do as well as other plans somewhat like it, but with little twists. But, before we get into those twists, here are the cons to Dollar Cost Averaging:
Your chance of missing out on a really good market move in a stock is increased. If you make a monthly buy your practice and a stock increases 30 percent in three months, if you had put the whole three month investment into making a purchase in the first month, you will obviously make more money at the end of three months than if you spread the investment out.
If you are looking to invest a large sum of money (say a bonus or inheritance), piece-mealing it into the market will clearly yield lower returns than making one or two large buys in a short period and managing those buys by "market timing" (but this strategy clearly adds stress to your daily activities, needless to say)
You may have a difficult time (mentally) making the buys when the markets are down (the fear factor) and thus may be more likely to miss good buying opportunities (obviously courage and stick-to-it resolve are needed to make this system work).
Finally, being invested in only three to four stocks is always a hazard, as you are not well diversified and thus better protected against one of the stocks taking a real "hit" due to unforeseen events.
WAYS TO MODIFY DOLLAR COST AVERAGING TECHNIQUES
Now, that I have laid out the pros and cons, there are several ways to overcome some of the cons and ways to enhance some of the pros. Here is the first of three I would suggest.
Dollar Cost Averaging With a Moving Average: This technique will require access to a computer that can add a 45-day moving average to a stock chart. A website called BIGCHARTS.COM will easily allow you to do this if you have a computer at hand.
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In this variation, if the current price is above the moving average at the time you invest, reduce your normal investment amount by 20 percent. If the current price is below the moving average, increase your investment by 20 percent. This simple adjustment to the program will generally improve results by nearly 25 percent over time, a very healthy margin of gain for such a simple adjustment.
The rationale here is that additional shares bought below the average will lower your average cost per share more, while the ones bought above the average will not impact your average share price nearly as much as the simple Dollar Cost Average system will.
Value Averaging Systems: This system, which is a pretty fair departure from the Dollar Cost Averaging method, is basically no more than setting a portfolio value wanted at some future date for the investment made today.
Here is an example. You begin with quarterly investments and invest $1,000 on day one. You determine that you want the investment to be worth $1,500 in three months (the next investment date). If the investment is worth $1,250 at the end of the three months, you only add $250 to have the value of your portfolio at the predetermined $1,500. Then you set a new value wanted at the end of the next three months, say $2,200. If, at the end of the second three months the value is only $1,700, you add $500 to get to your $2,200.
Your total investment for the six months in dollars is $1,750. Your profit is $450.
The return on your investment for the period is 25 percent. Not bad. Of course, you depend on the stocks doing well with this system and if they don't, you just make up the difference.
In good markets, this system will lower your cash investment if you shoot for 30 percent a year returns. But, in poor markets, be prepared to hike the dollars you will need to invest. Over the long haul, this system will beat the Dollar Cost Averaging system, usually. But you do have your work cut out for you and the worry of finding the cash every three months if the markets are acting poorly. Your choice.
Reducing Risk and Volatility for All the Above Systems: Now, I will give you a "kicker" to the two modified systems I have just told you about (you can use it on the Dollar Cost Averaging system, too).
Instead of using stocks for the investments, use index mutual funds. Sounds simple I know, but here are the plusses to doing so:
instant diversification over hundreds of stocks in the index fund;
reduction of costs required to purchase stock shares;
low management fees when compared to other types of mutual fund management fees;
much easier to access funds if necessary from time to time; and
reasonable assurance that your investment performance will be close to the index you chose.
For my money the best system is the modified Dollar Cost Averaging that uses the Moving Average addition to invest, coupled with using the index fund that follows the S&P index. Over time, the S&P has done well and the "sleep" factor is the highest of all the other variations that I have outlined for you.
Well, I trust that you will find this week's column helpful to your income investing program. As always, if you have additional questions you can e-mail me at NewsMax and I will do my best to get back to you in a timely fashion.
So, for now I hope your coming investment week is a good one. And you keep in touch. I do! See you next week.
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