After one of my recent presentations a student came up to me and asked how to invest in the stock market a just-received $1,000 windfall considering that the market is at all time high. He said: “What if I put my money in now, and the market goes down like many are predicting?”
“But what if it continues to go up?” I replied.
I went on to explain that nobody can see the future despite those who profess to know what the market will do next. The only thing I’m sure of, I said, is that stocks will do one of three things: go up, go down or stay the same. I added that unlike short-term traders who use probabilities to know whether to buy or sell – and they’re not always right – investors who are in it for the long term have to rely on other methods.
The best technique I know is dollar cost averaging.
It’s very simple. Invest the same amount of money at regular intervals. For example, employees with 401k accounts, often will invest the same amount of money each pay period. For those with regular IRA or other brokerage accounts, the same method applies.
The reason why dollar cost averaging works so well is that sometimes you buy when the market is high (share prices are high and you get fewer shares) and sometimes you buy when the market is low (share prices are low and you get more shares). Over the long term, you have smoothed out the ups and downs. Applying this method has the net effect of ‘averaging’ your purchase price of the stock or fund into which you’re investing.
I suggested to my student that he take the $1,000 and divide it up into equal amounts, say four amounts of $250 each and buy shares in his index fund over 4 months. If the market is indeed ready for a pullback – and it might be primed because stocks don’t go straight up or straight down without a respite and we haven’t had one in while – then he gives himself the opportunity to buy shares at a lower price when they drop.
Then he asked: “Why not wait until the market drops and buy at the bottom?”
“You can give it a try but when will you know when it hits the bottom?”
“Nobody knows,” I said. Nobody can regularly pick market tops or bottoms. Some folks can get lucky every once in a while and you’ll see them on CNBC touting their expertise. But the reality is that it can’t be done. If you could, then you’d never be wrong.
(I wasn’t even going to start on financial TV gurus and their poor track records. That’s a topic for another post.)
There are some dollar cost averaging haters out there. They cite studies that show if you get a huge windfall, than you’re better of investing it all at once and riding the ups and downs. Because the stock does have an upward bias over the long term, they conclude that you will eventually come out ahead. Yes, that’s true… technically speaking… but how many of us would be able to sleep at night if our $10,000 dropped 15 percent the day after we plunged it into the stock market?
I could handle it because I am not emotional about money or investing. However, for someone new to the market or naturally skittish about taking money risks, then dipping a toe into the water instead of diving right in is a better strategy. I hear too many stories from people about how they put all of their money into the market or a stock and it immediately went down. Some grit their teeth and hold on because people like me tell them it will eventually come back. Many others take their money out – at a loss. They’ve bought high and sold low which is not a recipe for financial success. More important, the experience has soured them forever on regular investing which is one of the best ways to become rich.
A former Washington correspondent for Business Week magazine, Larry Kahaner is the author of 15 books, including the best-selling Competitive Intelligence, a Book-of-the-Month selection that has been translated into six languages. He has also written Values Prosperity and the Talmud; Business Lessons from the Ancient Rabbis, The Quotations of Chairman Greenspan andAK-47; the Weapon that Changed the Face of War. Full bio.
His in-person, interactive, multimedia presentation titled Fiscal Fitness Boot Camp is available to colleges, universities and companies. You can email him directly at Larry Kahaner.
He is represented by Wolfman Productions, Inc.