Topic: Daily Advice

Why “averaging in” is rarely the best strategy for the conservative investor

Members of Pat McKeough’s Inner Circle enjoy a double benefit when it comes to taking advantage of our investment research. They get to address investment questions directly to me and my research associates; AND they get to see all other members’ questions, and our answers (of course, we eliminate any personal information).

Aside from specific investments (such as stocks, income trusts or exchange-traded funds), members ask us a wide range of other kinds of investment questions, as well. So you can get a sense of how the service works, I’d like to share an example of the type of question a more conservative investor might ask. I hope you enjoy and profit from it.

Q: Dear Pat, I’m a conservative investor who just received $50,000 that is important to my retirement (which is in about 12 years), so I have to invest this money carefully. The market has fallen lately, and I’m concerned that it could drop further. As a conservative investor, I would like to know if I should invest this new money in the stock market all at once or spread it out over a certain period of time. Thanks for your help.

A: Buying gradually may make you more comfortable than plunging right in, especially if you’re a more conservative investor. However, because of the way stock-market trends typically develop, it’s likely to cost you money in the long run. If you can afford to keep your money in the market for, say, five years, then the sooner you buy the better.

Long-term studies show that the stock market as a whole generally produces total pre-tax annual returns of 8% to 10%, or around 6% after inflation. Over periods of a few years or less, the return is far more variable and always uncertain. The surest way around this is to start investing when you’re young, and invest regularly over the course of your working years. Then you can sell gradually in retirement.

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In fact, if you invest a fixed sum at regular intervals throughout your working years, perhaps increasing that sum from time to time as your income rises, you can largely forget about stock-market trends. That’s because you’ll automatically buy more shares when prices are low, and fewer when they’re high. And you’ll benefit from the long-term rising trend in the market.

This investing technique is called dollar-cost averaging. It’s a little like systematic saving, except that you put your money into stocks instead of a bank account. However, some investors try to apply the dollar-cost averaging principle to lump sums by spreading their buying out over a period of time. That’s different. This gradual buying is sometimes referred to as “averaging in.”

For instance, you could average in by investing your $50,000 in the stock market by, say, purchasing $12,500 of shares every six months over two years.

Averaging in can be psychologically comforting. However, it will only improve your long-term results if you happen to begin when the market is headed down. Since the market goes up around two thirds of the time, on average, gradual buying is likely to cost you money.

If it lets you sleep easily, averaging in may still be worthwhile. But our view is that if you expect to be able to hold on to your stocks for, say, five years, then the sooner you buy, the better.

One final point: you plan to retire in about 12 years, but that’s when you begin dipping into your retirement savings. When you invest a lump sum gradually, you lower the risk of buying just prior to a market slump. However, holding off on going into the market means you generally invest in lower-yielding fixed-return investments for a longer period. This raises your risk of running out of money during retirement.

If you have investment-related questions like these, or if you’d like to ask me about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.

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