Stock markets are always volatile and there is always a risk that the markets go down thus taking your savings down with it. Many people fear losing their capital, and thus they will refuse to invest in the stock market because it is not safe enough. The fact is, many people invest with their emotions and overlook the simple truth that in the long run the markets tend to recover. Look at the great depression, the tech bubble burst, and the American housing meltdown. The markets just find ways to claw itself back to where it was. And for us that is all we need. Just look at the S&P index today. It finally reached back to the peak of 2007.
If you are a diligent investor and contribute monthly to your investment portfolio, then you are aware that short term fluctuations have little impact to your investment portfolio. It’s mere noise to your overall goal because you know that in the long run the value of your investment will go up. What you are also be doing by investing on a month to month basis is that you are taking advantage of what’s called Dollar Cost Averaging.
Little do people realize, buying into the market on a consistent basis actually helps you limit risk and even makes your portfolio grow when the markets remain flat over a long period of time. The idea behind dollar cost averaging is that you are not concerned about timing the market and waiting for a good opportunity to buy. You buy regardless of price. Whether the market is up or the market is down, you consistently purchase more shares. The way dollar cost averaging works is simple, you buy more shares when the stock market falls and you buy less shares when the stock market is up. This pattern of purchasing allows you to average your cost of the shares you own to something in the middle.
Below is a hypothetical scenario where if you had invested prior to the stock market crash in 2007 and kept on investing even through the crash to the current time. You would think that you would have lost all your money if you did that, but let’s look at it carefully. The initial price of the share was set at $10 to make the math a bit simpler.
* Values for S&P Index courtesy of Yahoo Finance
In this scenario, one would have to save only $100 a month and invested it in the S&P index on a quarterly basis. As illustrated by the chart, the guess that you would have lost all your money is not proven. In fact, you would have gained money had you continually bought more shares. There wasn’t any timing of the market involved. No extra money was put into your investment other than the $100 per month. There wasn’t even a need to pick a specific stock that outperformed the market. The only magic involved here is the concept of dollar cost averaging.
By buying shares on a consistent basis, the average cost of each share dropped to only $8.55. With a current market price of $10.84 this has created a cushion of $2.29 a share. What this means is that the stock market would have to drop 22% just to break even or better yet, a 27% gain was created on a stock market that went nowhere! Working out the numbers, this is an average of 4% annual return on the original principle. Try getting 4% on a GIC during that time period. I’m pretty sure that wouldn’t have been possible.
Using this strategy is only prudent if your commission fees to purchase shares are low. That’s why this strategy makes perfect sense for people who buy mutual funds because mutual funds don’t incur a transaction fee when they are purchased. This allows for more frequent purchases, maybe even at a monthly or weekly interval and makes dollar cost averaging even more effective.
So what’s the moral of the story? Stay invested. Stay focused. Know that your goal is somewhere far in the future and that bad news in the short term has very little effect on the growth of your portfolio so long as you stay the course.