Now that you know the characteristics of good stocks, you have to address the question of how to go about buying them. One of the biggest worries is timing. Suppose you’re unlucky enough to buy at the very top of the market? Or suppose something unexpected happens to dash the price of your shares overnight? How can you protect yourself against bad things happening to good stocks while you’re holding a basketful of them?
Dollar-cost averaging is a time-tested method of smoothing out the roller-coaster ride that awaits those who try to time the market. You don’t have to be brilliant to make dollar-cost averaging work, and you don’t even have to pay especially close attention to what’s happening in the stock market or in economy. With dollar-cost averaging, you simply invest a fixed amount regularly, depending on your saving schedule. The key is to keep to your schedule, regardless of whether stock prices go up or down.
Because you’re investing a fixed amount at fixed intervals, your dollars buy more shares when prices are low. As a result, the average purchase price of your stock will usually be lower than the average of the market prices over the same time.
Here’s an example of how dollar cost averaging usually works. Say you invest $300 a month over a six-month period in Acme Enterprises, a stock that ranges in price from a low of $20 to a high of $30. Here’s a look at what dollar-cost averaging would do. (This example ignores brokerage commissions.)
FIRST MONTH: The stock is trading at $30 a share. Your $300 investment buys ten shares of Acme.
SECOND MONTH: The market has taken a tumble and the price of your stock has fallen to $25. You buy 12 shares.
THIRD MONTH: Things have stabilized. The price of your stocks is still $25, and you buy another 12 shares.
FOURTH MONTH: On news of a takeover bid by another company, the price soars to $33. Your $300 buys you only nine shares, with a little change left over.
FIFTH MONTH: The takeover bid falls through and the price dips back down to $25. You pick up another 12 shares.
SIXTH MONTH: An earnings report that falls short of analysts’ expectations causes a couple of mutual funds to sell your stock, pushing the price down to $20 a share. You acquire 15 shares
LET’S ADD IT UP: So far you’ve spent, in round numbers, $1,800 (not counting commissions) and you own 70 shares of Acme, which means you paid an average of $25.71 a share. Compare that with other ways you could have acquired the stock: If you had bought ten shares during each of those six months, you’d own 60 shares at an average price per share of $26.33. If you had invested the entire $1,800 at the start of the period, you’d own 60 shares at $30 per share. You can begin to see the advantages of dollar-cost averaging.
Now, you might have noticed that at the end of the sixth month you were holding stock for which you had paid an average price of nearly $26 in a market that was willing to pay you only $20 a share. What now? Should you sell and cut your losses? Not necessarily. Now is a good time to reassess your faith in Acme; reexamine the fundamentals described earlier. If the fundamentals still justify your faith, this dip in the price represents a good opportunity to buy more shares.
Dollar-cost averaging won’t automatically improve the performance of your portfolio. But don’t underestimate the value of the added discipline, organization and peace of mind it gives you. It’s natural to be frightened away from owning stocks when prices head down, even though experience has shown that such times can be the best time to buy.
Because they charge no sales commissions, no-load mutual funds can be better suited for dollar-cost averaging than stocks. You’d incur relatively large commissions to buy a small number of shares of stock, and your fixed monthly investment might not buy whole shares. You can buy fractional shares in a mutual fund. Many funds will let you arrange to have money transferred regularly from a bank account, and some can arrange payroll deductions.
Although dollar-cost averaging lets you put your investments on autopilot, you shouldn’t leave them there indefinitely. Inflation and increases in your salary make your fixed-dollar contribution less meaningful over time, and you shouldn’t continue to buy any stock merely out of habit. Reexamine the company’s investment prospects on a regular schedule—at least once a year—and adjust your investment accordingly