Is NOW the right time to invest in the stock market?
"You know, five years from now, ten years from now, we'll look back on this period and we'll see that you could have made some extraordinary (stock market) buys. That doesn't mean it won't get more extraordinary a week or a month from now. I have no idea what the stock market is going to do next month or six months from now. I do know that the American economy, over a period of time, will do very well, and people who own a piece of it will do well." Warren Buffett CNBC, October 2007
O.K, I think Warren Buffett is a pretty smart guy, and many consider him one of the world’s greatest investors, but if he can’t tell where the market is going, the rest of us don’t stand a chance. How can we possibly tell when to get in the market?? (read the article)
Timing the Market
If you are like many people, the past several months have taken a toll on your investment and retirement balances, your patience, and perhaps your nerves. There is tremendous uncertainty surrounding the current market, and one of the results is a high level of volatility; large swings up and down in a short period of time. The thinking goes something like this: “If I don’t put money in now and the market rebounds, I’ll kick myself for missing the opportunity for a gain, but If I do make an investment now, and the market drops, I’ll kick myself for getting in too soon and losing money”. I don’t feel any better going to Vegas.
Dollar Cost Averaging
One way to counter the market timing mentality is to use Dollar Cost-Averaging(DCA), investing a fixed amount of money at regular intervals, whether the market is up or down. Think of it as buying more shares when they are “on sale”, and fewer shares when the market is high. This generally results in a lower average cost per share than if the investor had purchased a constant number of shares at the same periodic intervals.
How it works
Let’s say our investor has $6,000 to invest. They could purchase a single block of shares in a well diversified, low expense mutual fund in the beginning of the year, or they could invest $500 a month for an entire year. By investing a fixed amount each month equal to the amount invested up front in scenario 2, the investor ends the year with 57 additional shares and$3,236 more in overall value.
O.K, I think Warren Buffett is a pretty smart guy, and many consider him one of the world’s greatest investors, but if he can’t tell where the market is going, the rest of us don’t stand a chance. How can we possibly tell when to get in the market?? (read the article)
Timing the Market
If you are like many people, the past several months have taken a toll on your investment and retirement balances, your patience, and perhaps your nerves. There is tremendous uncertainty surrounding the current market, and one of the results is a high level of volatility; large swings up and down in a short period of time. The thinking goes something like this: “If I don’t put money in now and the market rebounds, I’ll kick myself for missing the opportunity for a gain, but If I do make an investment now, and the market drops, I’ll kick myself for getting in too soon and losing money”. I don’t feel any better going to Vegas.
Dollar Cost Averaging
One way to counter the market timing mentality is to use Dollar Cost-Averaging(DCA), investing a fixed amount of money at regular intervals, whether the market is up or down. Think of it as buying more shares when they are “on sale”, and fewer shares when the market is high. This generally results in a lower average cost per share than if the investor had purchased a constant number of shares at the same periodic intervals.
How it works
Let’s say our investor has $6,000 to invest. They could purchase a single block of shares in a well diversified, low expense mutual fund in the beginning of the year, or they could invest $500 a month for an entire year. By investing a fixed amount each month equal to the amount invested up front in scenario 2, the investor ends the year with 57 additional shares and$3,236 more in overall value.
Scenario 1 - Dollar cost Averaging
|
Invest date |
Amount invested |
Price per share |
Shares purchased |
Cumulative Shares |
Portfolio value |
|
Jan-08 |
$500 |
$40.00 |
12.50 |
12.50 |
$500 |
|
Feb-08 |
$500 |
$30.00 |
16.67 |
29.17 |
$875 |
|
Mar-08 |
$500 |
$19.05 |
26.25 |
55.41 |
$1,055 |
|
Apr-08 |
$500 |
$22.60 |
22.12 |
77.54 |
$1,752 |
|
May-08 |
$500 |
$22.60 |
22.12 |
99.66 |
$2,252 |
|
Jun-08 |
$500 |
$31.34 |
15.95 |
115.62 |
$3,623 |
|
Jul-08 |
$500 |
$60.00 |
8.33 |
123.95 |
$7,436 |
|
Aug-08 |
$500 |
$22.10 |
22.62 |
146.57 |
$3,239 |
|
Sep-08 |
$500 |
$54.19 |
9.23 |
155.80 |
$8,442 |
|
Oct-08 |
$500 |
$19.05 |
26.25 |
182.05 |
$3,467 |
|
Nov-08 |
$500 |
$31.34 |
15.95 |
198.00 |
$6,205 |
|
Dec-08 |
$500 |
$57.00 |
8.77 |
206.77 |
$11,786 |
|
Total |
$6,000 |
|
206.77 |
|
|
Scenario 2 -Lump Sum Purchase
|
Amount invested |
Shares purchased |
Cumulative Shares |
Portfolio value |
|
$6,000 |
150.00 |
150.00 |
$6,000 |
|
$0 |
0.00 |
150.00 |
$4,500 |
|
$0 |
0.00 |
150.00 |
$2,857 |
|
$0 |
0.00 |
150.00 |
$3,390 |
|
$0 |
0.00 |
150.00 |
$3,390 |
|
$0 |
0.00 |
150.00 |
$4,701 |
|
$0 |
0.00 |
150.00 |
$9,000 |
|
$0 |
0.00 |
150.00 |
$3,315 |
|
$0 |
0.00 |
150.00 |
$8,128 |
|
$0 |
0.00 |
150.00 |
$2,857 |
|
$0 |
0.00 |
150.00 |
$4,701 |
|
$0 |
0.00 |
150.00 |
$8,550 |
|
$6,000 |
150.00 |
|
|
You may already be utilizing a form of DCA by participating in your employer sponsored 401K plan. If not, you can accomplish a similar result with periodic contributions in an IRA account. For folks with a longer time horizon before retirement, who are more risk averse, this slow, steady approach can work well.
The Fine Print
This, like any other approach to investing needs to be part of an overall comprehensive plan. If you are working with funds you’ll need for retirement or college funding in the next couple of years, this probably isn’t for you either. For folks with a larger lump sum from perhaps an inheritance, retirement plan rollover or lottery winnings, support for DCA is less consistent (more on that in a subsequent issue). And of course you can get a higher return by just purchasing a lump sum and holding it in an increasing market, but that goes back to the earlier question of when should I get in the market? The answer is: often, consistently, using an appropriate allocation over a long time horizon.
And a final word from Mr Buffet on strategy for the “average” investor”
"Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time. Fortune ("What Warren thinks...", April, 2008)
John Davidson, CPA, is owner of KylesHill Financial Planning in Columbus, Ohio
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