Financial Advice
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

Coming Out Ahead in a Market Decline with Dollar Cost Averaging

Coming Out Ahead in a Market Decline with Dollar Cost Averaging

The extreme volatility on display in the stock market is enough to scare most investors out of the market. Many are content to wait on the sidelines until things calm down and the market returns to its long-term upward trend. That’s called trying to time the market and it rarely works. If it did, and investors were able to know when the stock market was going to go up or down, they would all be multimillionaires. No one can time the market with any degree of consistently. So, how should an average investor invest in the market if they’re concerned about the next big market decline? The answer is “dollar cost averaging” – an investment strategy that enable you to come out ahead even in a declining market.

How Dollar Cost Averaging Works

At its core, dollar cost averaging consists of investing a fixed dollar amount each month. The funds can be allocated among various mutual funds or exchange-traded funds that match your risk-return profile. That fixed dollar amount each month goes to purchase shares in those funds. When the price of those shares falls, that fixed dollar amount purchases more shares. When the share prices increases, it purchases fewer shares.

In a declining market, your fixed investment amount will continue to purchase a higher number of shares at lower prices. If you believe that stock prices will continue to rise in the long-term, just as they have over the last 125 years, then you can expect that the average cost of your shares at any given time will always be lower than the prevailing share price.

Here's an example of how you can come out ahead when stock prices go down. Starting your investment plan with a fixed dollar amount of $500 per month, you purchase 20 shares of a mutual fund trading at $25 a share. Over the next several months, the share price falls, enabling you to purchase a higher number of shares. As the share price increases, you purchase fewer shares. Over the period of 12 months it might look something like the following:

Month

Share Price

# Shares

1

25

20

2

24

21

3

23

22

4

21

24

5

20

25

6

22

23

7

23

22

8

25

20

9

26

19

10

27

18

11

27

18

12

28

17

Over 12 months you have purchase a total of 249 shares at an average cost of $24.25 per share. At the end of the twelfth month, the share price is 28. With a total investment of $6,000, you end the year with a balance of $6,972, which is a 16% annual return.

The advantage is you didn’t have to decide when to invest. You didn’t have to try to time the market, and yet you earned a very good rate of return.

With dollar cost averaging you can start or continue to invest in the stock market and come out ahead even when it declines. The key to the strategy is to commit to systematically investing a fixed amount each month (that can be increased as your cash flow increases) and to follow a disciplined investment strategy of broad diversification across several stock market segments. Starting out, it’s best to invest in a broad stock market index fund and then, as you accumulate more funds, you can diversify into other market segments.

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