Setting Up an Ongoing Investing Program
Step 1: How Can I Avoid Market High and Lows When I'm Ready to Invest?
The first step is always the hardest. And individual investors taking their first steps in an investment program must also confront a sea of stock market uncertainty. Some plunge headlong into the market with all their savings. Others barely wet their feet before heading back to the safe shores of their money market funds. The problem, however, with these two all-or-nothing approaches is one of timing—the risk of entering the market at a high point in the market cycle.
Dollar cost averaging and its variations, such as value averaging, offer investors an alternative, allowing them to ease into the market over time, which reduces the timing risk. The mechanical aspects of averaging provide an investment discipline, require no market forecasts and are relatively simple to initiate. Most mutual funds offer automatic investment and exchange programs—a cruise control for your investment plan that eliminates the more routine aspects of maintaining an averaging plan.
Dollar cost averaging is simple in concept: Invest a fixed amount at equal intervals and continue to do so over a long period. The result is that more shares of a stock or mutual fund are purchased when prices are relatively low and less are purchased when prices are relatively high. This can result in lower average per share cost over time.
Value averaging is a variation: Instead of investing a fixed amount each interval, the amount invested varies so that the total value of the investment increases by a fixed sum or percentage each interval. If share price increases alone cause the total value of the investment to increase above the planned fixed amount, then the investor must sell shares instead of adding to the investment.
Neither approach requires a forecast of market direction. And with both plans, the discipline of periodic investment during all market situations and the continuation of the plan over long investment periods—of five years, 10 years, 20 years or even longer—provides substantial benefits, not the least of which is simply getting started in an investment program in the first place.
Investors who should use dollar cost averaging or value averaging include:
One key to the successful use of an averaging approach is to choose an appropriate long-term horizon. In order to avoid the potential disaster of placing a substantial portion of your portfolio in risky investments at the high point of a market cycle, take a minimum of two years, investing monthly or quarterly, to complete the move into the market. Five years is an ideal period, albeit a bit too long for many impatient investors.
- Any investor with a pool of cash or periodic cash flows who seeks to invest in a risky asset, who has a long-term investment horizon, and who feels that he cannot forecast short-term moves in the market.
- Any investor who is having difficulty finding the right moment to move into the market (or back into the market if he was temporarily out of the market).
Those investors without a significant pool of cash currently available but who instead have cash periodically available are spared the temptation of rushing a large sum into the market all at once. These investors are already structured for dollar cost averaging, but without a plan, they may never start an investment program.
Another consideration is the frequency of the investments. Any periodic interval could be used and, of course, any amount or value. Investing often enough over a uniform time interval is important and every quarter, two months, or every month is reasonable. Investing weekly, however, is probably overkill, while waiting every six months or every year to invest is too infrequent and may defeat the benefits of diversifying the investments over time in an ever-changing market.