Now that the market has surpassed its previous record, many who bailed out with the herd after the 2008 collapse are now feeling edgy about having missed the surge back and are probably wondering, "what is the smart way to buy back into the market?"
Now that the market has surpassed its previous record, many who bailed out with the herd after the 2008 collapse are now feeling edgy about having missed the surge back. So the question comes up, "what is the smart way to buy back into the market?"
We know that we should maximize our tax-deferred accounts, such as IRAs and 401(k)s. And we know that we best minimize risk of the unpredictable market by diversifying our investments into a small number of different types of vehicles/funds. Small-cap stocks, large-cap stocks, bonds, international, REITs (real estate) and so on. And we know by now that it is important to keep the overhead of trading costs, management costs, etc., to less than 1%, such as by buying ETFs (exchange-traded funds). We've also learned via many studies, although the memo does not seem to have penetrated the greater public, that WHAT you buy is much less important than HOW you buy.
So I thought it would be useful to review an old, but time-tested way of buying into the market and minimizing the timing risk. This is called “dollar cost averaging.” The idea is to commit the same amount of money on a monthly or quarterly basis over a long term whether the market goes up or down and to spread the money equally into each of your investment sectors. This has been proven to maximize your chance to buy low and minimize buying high. It's simple to understand and to execute and it works. You can even put the withdrawals on autopilot.
A more sophisticated improvement on the system for more advanced investors — also shown to work by numerous economic studies — is called “value averaging.” This approach says that each month, or quarter, you add to your account in a way that the total portfolio value increases by a set amount regardless of market fluctuations. So you are focusing on increasing your total value by a fixed number rather than having the amount you add be a fixed number.
So if the market is rising, you do not have to put very much into your account that month to make your value increase goal; you are buying less when the cost per share is higher. Conversely, when the market drops, you are putting more in that month or quarter; you are maximizing the "buy low" aspect. It works out that the more volatile or extreme the changes in the market, then the bigger the advantage value averaging has over dollar cost averaging.
Dollar cost averaging works for you if you do not want the hassle of periodic juggling involved in value averaging and prefer the ease of putting in little thought or effort once you set up your automatic withdrawals. Value averaging, while not difficult or complicated, does require some attention and effort every month/quarter.
One other aspect to consider if you are interested in re-investing in the market is what to do with a lump sum, if you have one; jumping in all at once or easing back with periodic additions. Again, you do not have to re-invent the wheel because economists have looked at this question many times.
The bottom line is that over the long-term, putting in any lump sum that you have available produces a higher yield than parsing it out bit by bit over time. Maybe because most of the market's gain is in untimeable spurts and having all of your money in earlier means that you are ready to maximize any gains.
Investing is all about time and timing, after all. Fr reasons unexplained, two studies from Wright State economists in Dayton, Ohio showed the maximum benefit for a one-time contribution comes when you make a January lump sum dump (sounds like a Chinese dish…).