Taking the Guesswork Out of When and
How Much to Invest
By Austin Pryor with Joseph Slife
© Sound Mind Investing | June 2011
You are more likely to be a successful investor over the long haul if your investing decisions and actions flow from specific, predetermined guidelines. An old saying offers good advice: "Plan your work and work your plan." We would add: "…regardless of the news of the day or the speculations of market prognosticators."
Although guidelines for choosing specific funds are inherent in our core strategies (Just-the-Basics and Upgrading), two questions remain: How often should you invest? And how much should you invest at a time?
A simple way to make these decisions is to use a "formula" approach — i.e., one that eliminates inconsistency and guesswork.
The best-known formula for answering the how much/how often questions is called dollar-cost-averaging (DCA). It's neither complicated nor time-consuming. Here's all you do: (1) invest the same amount of money (2) at regular time intervals. The amount and frequency are up to you. The important thing is to pick an amount you can stick with faithfully over many years.
The beauty of DCA is that it frees you from worrying about whether you're buying stocks at the "wrong" time. Because your dollar amount remains constant, you'll be getting more shares for your money when stock prices fall and fewer shares when prices rise.
In effect, you'll buy more at bargain prices and less at what might be considered high prices. (Of course, only when you look back years from now will you know when prices were truly bargains and when they were too high.)
For DCA to work, however, it is critically important that you ignore all market fluctuations. Most investors who end up with poor returns are victims of their own emotions. Only after stock prices have been rising sharply do they work up enough courage to buy. Then, when prices plunge, they become fearful and sell. The consequence is that they "buy high and sell low," the very opposite of their intention.
It is important, therefore, not to let your emotions control you. If you're going to use dollar-cost averaging, you must exercise the discipline of maintaining your systematic investment program.
CAUTIONS AND CRITICS
Understand that dollar-cost averaging isn't a cure-all. For one thing, it doesn't protect you against losses. While DCA does result in your average cost per share being lower than the average price of the shares over time, in a bear market you can still suffer temporary setbacks.
Furthermore, DCA can lower your potential profits. Let's say you invested every month in a mutual fund in which the share price rose steadily all year long. In that case, you would have enjoyed greater gains if you had made a single large investment early on, rather than making investments over time.
Indeed, because the market has a long-term upward bias (i.e., it has always moved higher over time), some analysts argue that DCA is a bad idea. They note that you'll pay more for shares (on average) if you stretch out your buying than if you invest as much as you can as soon as possible.
That's all well and good when you're looking back over a 40-year period with the confidence that comes from 20/20 hindsight! But it ignores bear-market periods along the way that can frighten investors out of the market altogether.
For example, if you invest your $50,000 inheritance just before a bear market wipes out $10,000 of it, will you have the stomach to stay around and wait for the next bull market to recoup your losses and move you into the black? Perhaps, perhaps not.
So the academics have it right in theory, but in the real world DCA makes it much easier for investors to overcome their fears and make the difficult decision to put their savings at risk.
REASONS TO LIKE DCA
In summary, dollar-cost averaging is the systematic investing of a fixed amount of money on a regular basis, usually monthly. DCA has these benefits:
- It eliminates the need to ask, "Is this a good time to buy stocks?" As far as DCA investors are concerned, every month is a good month.
- It imposes a discipline — a structure for making "installment payments" on your future financial security.
- It causes you to buy relatively more fund shares when prices are low and fewer shares when prices are high.
- It helps you "automate" your investing, thus eliminating the risk that you'll forget or be distracted by the market news of the day.
Dollar-cost averaging can be especially helpful in conjunction with no-load funds because such funds allow the purchase of fractional shares, eliminate commission costs, and offer sufficient diversification to reflect the stock market at large. DCA is also an excellent technique to use with 401(k) and 403(b) retirement-plan investing.
There's no single "right" way to employ DCA — the timing and the amount are entirely up to you. And you may want to add a tweak or two, such as employing monthly or annual seasonality. Just be careful that you don't overcomplicate an uncomplicated system.
DCA AND SMI
Does dollar-cost averaging mesh well with SMI's core strategies of Just-the-Basics and Upgrading? The answers, respectively, are "absolutely" and "not so much." DCA and Just-the-Basics are a natural match, since the JtB strategy employs a static (i.e., unchanging) index-fund portfolio. You simply keep investing the same amount into the same funds on a regular basis.
Using DCA with Upgrading, however, can be problematic. Here's why. To discourage overly active trading, most brokers require investors to hold funds for either 90 or 180 days. So if you add money to SMI's recommended funds on a monthly basis, you will be assessed a short-term trading fee every time you sell, because you will have invested money within the 90-day (or 180-day) window. (Exception: Fidelity doesn't require a holding period for its in-house funds if they are purchased through Fidelity.)
The simplest solution to this problem is to bypass it altogether. This can be done by making your regular contributions into one of the SMI Funds (SMIFX or SMILX) instead of Upgrading manually on your own. Using the SMI Funds allows you to gain all of the benefits of DCA, immediately allocating each new investment across the risk categories used in Upgrading, and putting your money to work right away.
Those opting for this approach would likely want to set up their account directly with the SMI Funds in order to avoid any transaction fees on new purchases. Otherwise, buying SMIFX or SMILX through a broker will create regular transaction fees with each purchase that will largely offset the benefits of DCA. (You can learn more about the SMI Funds at www.smifund.com. Be sure to read a fund's prospectus, including information about expenses, before investing.)
If you decide to Upgrade manually rather than use the SMI Funds, there are two main DCA approaches. One is to buy systematically, but when recommended funds are sold, sell only the portion that has been held longer than 90 days (or 180, depending on your broker). Then simply wait until the holding period is complete before selling the remaining shares that would otherwise be hit with a fee. This will work, but can get unwieldy, especially if you're trying to keep track of buy/sell dates for multiple funds.
Another option is to dollar-cost average into your broker's money-market fund as you wait for new SMI recommendations, then put these larger sums to work when new funds are recommended. But this approach essentially leaves your money sitting idle for months at a time, and can throw your asset allocation among risk categories out of whack.
Regardless of the particulars of how you choose to implement dollar-cost averaging, consistency is the key. Keep in mind Proverbs 21:5, "Steady plodding brings prosperity" (TLB). 
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Austin Pryor is the founder and publisher of the Sound Mind Investing newsletter and website. His desire is to help people understand and apply Biblically-based principles for making spending and investing decisions, ultimately helping them have more so they can give more. |
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Former SMI staffer Joseph Slife is now the senior producer and co-host of The World & Everything in It, a weekly radio program produced by WORLD magazine that can be heard here. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting. |
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