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Dollar cost average investing works well in bear markets
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This is a parable about two retired farmers.
Farmer #1
The first farmer sold his farm in October 2007 and put his two-million dollar after tax proceeds into a well-known and respected S&P 500 Index Fund.
Today, he has a little more than half of what he originally invested in the fund, and is considering going back to work. This is the tragic consequence of poor planning, bad timing, and lump sum retirement or inheritance investing.
Farmer #2
Our other farmer also sold in October 2007. He put his entire two-million dollar proceeds into a well-established money market account.
He then spent the next weeks executing his personal plan to diversify his retirement nest egg. His plan was simple, conservative, and complete. He organized his retirement money to last two lifetimes – his and his wife’s. He built his plan as he built his farm – slow and steady.
Find the right investment company
Farmer #2 selected an investment company that provided free financial tools, and set up an automatic investment plan that would get him to his first goal of investing 30% of his two-million dollars in the stock market – by October 2008.
Realize what you don’t know, and learn what you can
Our second farmer was not schooled in financial investing, and was skeptical of the “experts” who he watched advise his friends into dubious investments in the markets.
He did know that the market is cyclical, and had been bullish for several years, so he figured that it might be in for a correction – therefore, he decided not to invest his entire 30% in one lump-sum purchase.
Total market index funds are low cost ways to ride the market northward
Since he knew little about individual stocks and sector funds, he decided to risk his savings on the results of the entire market. He opened a low cost total market index fund with the minimum allowable investment of $3,000 and set up daily purchases of additional shares.
In order to reach his 30% goal by October 2008, he automatically invested $2,500 every day the market was open.
As the weeks and months rolled by our second farmer was glad that he had the patience to invest daily instead of buying a lump-sum of stocks back in October 2007. Every day he watched as his $2,500 purchase bought more and more shares as the market declined.
Dollar cost averaging vs. lump-sum investing
It is fair to note that critics of dollar cost average (DCA) investing argue that if the market turns bullish, or stays consistently bullish for a long period, lump sum investing is a better choice because you can purchase more shares today than you will be able to buy tomorrow if the market is surging upward.
However, our second farmer knew the market had been bullish for some time, and he is conservative by nature. He didn't feel he needed to hit a home run with his hard earned investment dollars, and he could not afford to lose his fortune on one bet - because he did not have the years to make it up.
He correctly estimated the market's downside risk to be much greater than the upside opportunity in October 2007. He chose to dollar cost average.
He was a little uneasy as he saw his cautiously invested stock market dollars slowly shrink, but our man understands business, and has faith in the global marketplace. He firmly believes that eventually, the stock market will recover and exceed its 2007 high.
Investors just entering the market have the advantage of knowing where the market has been
Farmer #2 can afford to be patient because he is a new investor who heretofore had all his saving eggs in his farm basket, which by the way he realized was a big gamble – that fortunately worked out for him and his family.
Our second farmer reached his stock purchase goal by October 2008. He owns many more shares of his index fund than he had originally imagined, but his approximately $600,000 investment is now worth only about $500,000. The difference is an amount he can afford to lose, but no one enjoys losing.
He decided not to completely rebalance his asset allocations in 2008, and he knows that dollar cost averaging works well in bad or questionable markets, so he continues to invest $100 per day into his index fund.
He already has plans to sell some of his shares when the market recovers and reaches a specific level – after which he will increase his daily dollar cost averaging purchases to prepare for the next plateau.
His selected index fund is up about 4% for the year, and is currently yielding about 2.5% – more than some of his CDs.
Our investor is sweeping all his capital gains and dividend payments into his money market account, which (before taxes) pays for about half of his automatic daily $100 fund purchase.
Farmer #2 is now comfortably diversified with other conservative investments. He and his wife are enjoying the travel they could never do while they operated the farm.
Now it is just a matter of time as he waits to reap what he has been careful to sow in his dollar cost averaged stock market purchases.
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