When you practice a “dollar-cost averaging” investing strategy, you invest equal amounts of money (say $300 a month) over a specific period. It’s a little like systematic saving, except you put your money into stocks instead of a bank account.
Investing strategy: How dollar-cost averaging can help you profit from long-term market trends
Long-term studies show that the stock market as a whole has generally produced 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 investing strategy for getting around this uncertainty is to start practicing dollar-cost averaging as early as possible, and invest regularly over the course of your working years. Then you can sell gradually in retirement.
In fact, if you invest a fixed sum at regular intervals throughout your working years, perhaps raising that sum from time to time as your income rises, you can largely forget about 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.
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Dollar-cost averaging by the numbers
Here’s an example of dollar-cost averaging in action: Let’s go back 10 years, to January 2, 2001. Say you receive $1,500 a year as a holiday bonus from your employer. Every year, as part of your dollar-cost averaging investing strategy, you use these funds to buy shares of Canadian Tire Corp. (symbol CTC.A on Toronto), one of the stocks we analyze in our Successful Investor newsletter.
On January 2, 2001, Canadian Tire shares closed at $19.10.
Over the following years, Canadian Tire shares rose to over $85 (in 2007), fell below $40 (in the market downturn of 2009), and rebounded to $68.77, where they closed on Tuesday, January 4, 2011, when you would have made your latest purchase.
However, thanks to your dollar-cost averaging investing strategy, you would’ve bought more Canadian Tire shares when they were low and fewer when they were high. So, if you bought Canadian Tire shares on the first trading day of every year from January 2001 through January 2011, your average cost would have only been $55.83 a share.
That means you would be ahead of today’s price of $67.39 by $11.56 a share, or 20.7%.
It’s worth noting that this gain doesn’t include Canadian Tire’s dividend payments, which have risen significantly over the past 10 years. In January 2001, the company paid an annual rate of $0.40 a share. By late 2010, that payout had risen to an annual rate of $1.10, for a 1.7% yield.
Know the difference between dollar-cost averaging and “averaging in”
Dollar-cost averaging works best when applied over long periods, ideally throughout your working years. It is much less effective, and can actually cut your returns, when you apply it over shorter periods. This type of gradual buying is sometimes referred to as “averaging in.”
For instance, say you have $50,000 to invest. 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, this investing strategy 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.
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