Saturday, November 5, 2011

How to Combat Market Anxiety with Dollar Cost Averaging

In today’s unpredictable and volatile economic times all I see are people watching the rollercoaster ride of the stock market on a daily basis and just driving themselves crazy. I hear co-workers discussing how much the stock market dropped today and how their investments are going down the drain. I hear people worrying about their retirement and wondering if they are even ever going to be able to retire someday. I see people saving more of their money – which is good - but because of their fear in the stock market, they invest in super-conservative investments that aren’t even keeping pace with inflation.

If you can relate to any of the people I mentioned above, I hope that by reading this and learning more about Dollar Cost Averaging, you may just be able to sleep a little bit better at night. By the time I am finished, I hope to change - in a positive way - the way you think about all of the unpredictable ups and downs in the stock market.

So, what exactly is Dollar Cost Averaging? Well, Dollar Cost Averaging is simply investing a fixed amount of money at regular intervals over a period of time.

To demonstrate the power of Dollar Cost Averaging I will be comparing two extreme market conditions using two fictitious investors – Jack and Jill. They will each be investing $100 per month and we will be looking to see how well each of their investments did over a period of one year.

Let’s start with Jack (the green line in Figure 1). On the first month he puts his $100 into a fund with a $12 share price. The next month the share price goes up a little bit, and then the next month it goes up a little bit more, and then a little bit more, etc. The steady rise continues and by the end of the year the share price tops out at $17.54. Jack is pretty excited because he realizes that all of his shares are now worth $17.54, even the ones that he bought for $12! The share price’s steady rise from $12 to $17.54 represents a 46% increase! This is a classic example of steady market growth.

Now, let’s look at how Jill did (the blue line in Figure 1). On the first month she too invests her $100 in a fund starting at $12 a share just like Jack. But, then a month later it dropped all the way down to $8, and then down to $6, then back up to $8, then down to $6, then down to $4! After a few more unpredictable ups and downs, it finally made it back to where it started, at $12 a share. At this point, Jill is not extremely happy with the results, but she is glad that she is at least out of the negative and now breaking even. In this case, Jill started the year at $12 a share and finished the year at $12 a share, representing a 0% increase. With all of the ups and downs, this fund probably looks a little familiar – it looks a little bit like the current stock market, doesn’t it? We call this a volatile market.

So, if this was the only information that was given, and you had to choose between Jack’s investment (the green line) and Jill’s investment, which investment do you think most people would choose? Most people would probably choose Jack’s investment, Right? – The one with the steady growth.

Figure 1

Let’s get a little bit more information and see if this is still the correct decision.

So let’s go back to Jack’s investment (the green line in Figure 2). The first month, Jack’s fund cost $12 a share, so with $100 he could purchase 8.3 shares. The next month the cost was a little higher, so he could buy a little less or just 8 shares. For the rest of the year the price kept going up so Jack was able to buy less and less shares each month. Finally, at the end of the year, if you were to add up all of the shares that were bought during the course of the year it would have totaled 82.2 shares. But since, at the end of the year, the share price was $17.54, that means that all 82.2 shares were worth $17.54 each – even the ones that were bought for $12. So, if you multiply the $17.54 by 82.2, you get the total value of the investment $1,441.79. That’s a $241.79 profit for the year, since Jack already paid into it $1200 by investing $100 a month for 12 months. That’s not a bad profit for one year of investing, but did you realize that by ending up with $1,441.79 by investing $100 a month, that Jack made a rate of return of 39.33%?

Now let’s look and see how Jill did.

Jill (the blue line in Figure 2), just like Jack was able to buy 8.3 shares on the first month, but when the share price fell the second month, she was able to buy 12.5 shares with her $100. Look at when it dropped to $4 a share at the end of June – she was able to buy 25 shares at this time. At the end of the month, Jill’s share accumulation was 161.7, almost twice as many as Jacks! Of course her share price was lower, but if we multiply the year-end share value $12 with the 161.7 shares and you get a total investment value of $1,940.40! That’s a $740.40 profit and an unbelievable 100.5% rate of return for Jill!!

Have you ever heard of an optical illusion? Well this is a financial illusion!

Figure 2

One key thing that I hope you get out of this, besides the fact that it is unhealthy to watch the market on a daily basis, is that if you do look at your investment often, pay more attention to the share accumulation and not so much to the share price. When the media reports on a stock rising or dropping, they are just reporting on its share price.

Some other important things to know about Dollar Cost Averaging
  1. “Dollar Cost Averaging” is a lot like gravity -- it works whether you believe in it or not. If you are participating in a 401k plan, it is already working for you, even if you are unaware.
  2. “Dollar Cost Averaging” automatically insures that you will buy more shares at a lower price and fewer shares at a higher price, over the long term.
  3. “Dollar Cost Averaging” can work for you even if you are not adding any new money. If the investment is in equity mutual funds, even if no new money is added, the “Dividends” and the “Capital Gains” can be periodically reinvested to buy more shares.
  4. “Dollar Cost Averaging” does not work in an interest bearing account down at the Bank!
You see, by not understanding Dollar Cost Averaging or how it works may make people more inclined to pull their money out or at least stop investing, when the stock market takes a dive. But not you – hopefully by now you understand that the market always goes up and down in unpredictable ways and always will. And Dollar Cost Averaging automatically insures that during market lows you will be able to buy more shares and when the market goes back up your investment can compound and grow.

So, the next time you hear about a major decline in the stock market, I hope you remember this concept of Dollar Cost Averaging and think of it more as an opportunity and not so much as a crisis.

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any comments, please post them below, otherwise, feel free to contact me.
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