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Monday, May 11, 2009

Meaning of Dollar-cost Averaging

The Meaning of Dollar-cost Averaging
They say a rising tide lifts all boats. It's only true if your boat isn't swamped by a wave.
All investing involves risks, and investing in the stock market may seem especially risky because stocks can exhibit great volatility. The optimism of the Roaring Twenties ended with a bang on "Black Thursday" (October 24, 1929), when the Dow Jones lost nearly a quarter of its value in one day-and went on to lose 80% of its value by July 1932 (it took two decades to recover). On the other hand, several "historic" market downturns have reversed very quickly; the 40% drop of 1987 vanished in less than 18 months, and was followed by a very strong boom decade.
Paradoxically, despite all this diving and soaring, the stock market has the potential to be one of the most rewarding forms of investment in the long run. This hypothetical graph covering the last seventy years shows great crests and troughs, but also a strong and persistent rise in overall values.*
Looking at the detail in a chart like this, many investors are seduced by a deceptively simple idea: buy cheap. They think they should hoard spare cash, wait for a downswing, and then pounce on bargain investments at the "right moment."
The "right moment" — what a wonderful idea. A few of those who follow its siren voice have become wealthy — but far more have lost out. Why? Because timing the market is harder than predicting the weather.
Even professional brokers and analysts find timing the market extremely difficult — and these are people with advanced financial degrees, whose full-time job is to keep tabs on the market.
So it turns out that a far wiser strategy, for the majority of investors, may be to treat investing in the stock market exactly like a savings account — or a piggy bank. You decide on an amount (let's say $200) that you can afford to deposit every week or month. You add that much to your investment at the predetermined interval, regardless of the current price of the stocks.
The result is "dollar-cost averaging." If a stock rises and falls, you'll sometimes be "buying high" and sometimes "buying low," relative to a stock's long-term performance. But it also means that you keep adding to your portfolio in a consistent manner. You don't focus on crests and troughs. You avoid both the temptation to "play the market" and the risks involved in getting it wrong.
Getting the best out of the stock market doesn't just mean choosing good stocks. You also need to ensure that, on average, your money does as well as those investments do. Hence "dollar-cost averaging" — AKA "choosing an amount to invest, investing that amount regularly, and not overreacting to the day-to-day stock price" — is a big step in a sensible direction.
The stock market comes with absolutely no guarantees. It's reasonable to expect that investing in solid, "blue-chip" companies expose you to less risk than investing in an untried start-up that may (or may not) be the next decade's Microsoft. As we have seen, even the established Microsofts of the world are not immune to a chill financial wind.
"Dollar-cost averaging" is a technical term only economists could love, but it conceals a very simple, very good idea. There's relatively strong historical evidence that good-quality stocks are a rising tide in the long run. On the other hand, big waves can blow up out of nowhere — and about the worst thing you can do in a heavy sea is try your hand at surfing the crests.
*Past performance is not a guarantee of future returns.

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