Dollar-Cost Averaging: The Investor’s Cure to Coronavirus
A lot of people have been asking me lately if it is time to get back into the stock market. I can’t blame them. The S&P 500 Index dropped 30% over the past two months. That’s the fastest it has ever fallen that far.
Of course, there is no way of knowing when the stock market has bottomed out until well after the fact. At the moment, the near term fate of the stock market will be determined by the future direction of the novel coronavirus pandemic.
If the virus weakens over the next few weeks, now should be an excellent time to buy stocks. But if it morphs into a runaway freight train, the stock market could have much farther to fall.
For that reason, I am reluctant to guess precisely when the stock market has bottomed out. However, you don’t need to know that in order to profit from its eventual recovery. Instead, you can dollar-cost average (DCA) into the current downturn to take advantage of reduced stock values. It works like this:
- First, specify the amount of money you can commit to new investments.
- Second, select a time horizon over which that money will be invested.
- Third, identify an investment portfolio into which that money will be transferred on a periodic basis over your chosen time horizon.
Once you have made those decisions, your broker can do the rest for you. At that point, all you have to do is sit back and let the mathematics of DCA work in your favor.
Making the Math Work for You
The math works like this. During periods when stock prices are high, your periodic purchase will buy fewer shares. When stock prices are low, that same dollar amount will buy more shares. Over time, your average cost per share purchased should be lower than the average share price over the entire period.
Let’s look at a simple example. You have $6,000 to invest over the next six months. On the same day each month, $1,000 will be transferred from your money market account into a mutual fund. During the first three months, the fund’s share price drops by a dollar each month. Then, it bottoms out and rises by a dollar each month.
At the end of six months, the fund’s share price is right back to where it started. Had you simply invested all $6,000 at the beginning, your account value would be unchanged. However, under the DCA plan, your account value would be worth $6,722 for an immediate gain of 12% as shown below.
Of course, a DCA plan only works in your favor if the investment bottoms out at some point during the investment period. If it does not, you would still have a net loss. For that reason, it is critical that the DCA investment period be long enough to allow time for the market to recover.
Most DCA plans run for 6 or 12 months. Now that the stock market is already down 30%, a 6-month plan may be sufficient. But if you are concerned that the virus may rage on into the fall, a 12-month plan might be the safer play.
Either way, once the DCA plan is in place you should sleep more soundly at night. You will view the stock market’s huge drops as working in your favor, driving down your average cost per share.
Also read: How to Fight the Bear…and Win
If you are an active participant in a 401k plan, you have been dollar-cost averaging all along. Every pay period, the funds in your portfolio are purchased at the current share price. If you are not yet participating in your employer’s 401k plan, now should be a good time to get started.
If you do not have access to a 401k plan, you can still benefit from dollar-cost averaging by setting up a Systematic Investment Plan (SIP) with your broker. The process is essentially the same, although the money will not be directly transferred from your pay. Instead, you will first need to deposit the money into your brokerage account.
I would not wait long. I am seeing stocks trading at prices I thought we’d never see again. Ford Motor Company (NYSE: F) traded below $5 this week while General Electric (NYSE: GE) fell beneath $7. That could go even lower, but not by much. And once they start to recover, it may happen so fast that you won’t have time to act.
I also wouldn’t wait to seek the advice of my colleague, Jim Fink.
Jim Fink is the chief investment strategist of the premium trading service Velocity Trader. Jim has devised a proprietary investing system that has delivered 20,747% in profits to Investing Daily readers in less than five years…including a three-and-a-half-year winning streak in which they’ve raked in gains of 18,186%… without a single loss.
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