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Defensive Investing: Use Dollar-Cost Averaging to Reduce Volatility Risks

InvestorEducation / Learning to Invest Aug 11, 2010 - 12:05 PM GMT

By: Money_Morning

InvestorEducation

Best Financial Markets Analysis ArticleLarry D. Spears writes: Dollar-cost averaging has long been a strategic staple among mutual fund buyers. Longer-term investors use it to smooth out the effects of short-term price fluctuations, but the tactic seldom has been practical for purchasers of individual stocks - that is until now.


For those unfamiliar with the strategy, dollar-cost averaging - also known as constant-dollar investing - involves the regular purchase of a smaller fixed-dollar amount worth of shares over time, as opposed to the lump-sum purchase of a large number of shares at once. For example, rather than buy $1,200 worth of shares of fictitious company XYZ in January, you might buy $100 worth of XYZ shares each month for the full year.

The technique offers several advantages for fund investors:

•Because you are investing a fixed-dollar amount at regular intervals, you don't have to be concerned with trying to time the markets.
•Since the fixed-dollar amount you invest buys more shares when prices are low and fewer when they are high, your average cost basis levels out over time. This reduces the risk that you might pay too high a price by making a lump-sum purchase at the wrong time.
•The lower average cost basis mutes the impact of short-term volatility on your existing holdings.
•You can build a sizable position in a single fund, even if you never have a large sum of money to invest at any one time.

Historically, the strategy has worked best with "no-load," "low-load" or "back-end load" funds, - which have little or no sales commissions, or commissions charged only when you sell your shares - though many fund families offer special dollar-cost averaging plans on even their load funds.

The technique typically didn't work as well on individual stocks because of high fixed-commission rates, surcharges for trading "odd lots" (fewer than 100 shares of stock) and a lack of willing small-lot sellers, which resulted in unfavorable bid/ask spreads and poor liquidity.

That began to change on May 1, 1975, when the Securities and Exchange Commission (SEC) abolished the system of fixed brokerage commissions (typically, 8.5% to 9.0%), allowing for the introduction of discount brokers. The trend toward low-cost, more-efficient trading then accelerated in the late 1990s with the advent of online brokerages and electronic trading networks (ETNs).

Now, low commission rates make costs on even the smallest stock trades reasonable and the computer-executed market price will usually be the same on one share as on 1,000, with liquidity seldom an issue.

That makes dollar-cost averaging with individual stocks more practical, but is it really advisable?

Some analysts say yes, if only because of the psychological benefits. No one - not even the pros - can perfectly time the market, so spreading out stock purchases can ease the stress of making trading decisions. You don't have to worry about buying at exactly "the right time" - and you have reduced emotional exposure when large single-day moves such as May's "flash crash" roil the market.

Other analysts say no, contending that spreading out stock purchases leaves assets unallocated or in the wrong place. They also note the stock market's inherent upward bias over time, arguing that the sooner you invest, the better your results will be long term.

Money Morning Chief Investment Strategist Keith Fitz-Gerald, says both arguments have their merits.

"It really depends on the market environment at any given time," Fitz-Gerald explains.

"If the market - or an individual stock you're considering - is in a recognizable uptrend, with solid fundamentals and good technical support, then dollar-cost averaging your way in is a bad idea. Go ahead and make the lump-sum investment so all of your money will benefit from continuation of the upward trend."

However, if the market is dominated by uncertainty - as it has been for most of 2010 - a modified form of dollar-cost averaging can be a smart approach to investing in specific stocks, Fitz-Gerald says. It gives you the opportunity to take advantage of big short-term price swings rather than suffering because of them.

"For the past few months, I've been advising readers following my recommendations not to plunge in all at once," he said. "I've suggested they break their money into fifths and look to buy in with a fifth on days after a big price drop or a three- or four-day downward swing. Given the market's recent behavior, that has let us build full-sized positions at a much lower average cost over a reasonably short period, setting us up to quickly profit when the market swings upward again."

Basically, you also shouldn't wed yourself to just one strategy - either dollar-cost averaging all of the time, or none of the time. If a stock's trend is clearly upward, forget about averaging in and immediately invest your funds. If there's a significant downside risk, or the overall market is volatile, dollar-cost averaging makes more sense. You also might set a trailing stop based on the average cost of your position to that point, then exit if that stop is hit and look for better opportunities elsewhere. [Editor's Note: Click here to read an example of how dollar-cost averaging might benefit an investor.]

If you do choose to dollar-cost average into a stock, it will be cheaper to use a discount broker. Some online brokers, such as Scottrade Inc. E Trade Financial Corp. (Nasdaq: ETFC) and others often offer free trades to new account holders - meaning you can dollar-cost average on a couple of stocks and pay no commission at all.

Source : http://moneymorning.com/2010/08/11/dollar-cost-averaging-2/

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