A Bull Market is when prices of stocks generally rise over a period of time. It is named such because a bull attacks with its horns up in the air. A Correction is a stock market decline of 10 per cent or more. A Bear Market is when a stock market declines 20 per cent or more. It is named such because a bear attacks with downward sweeps of its paws. Investors want to buy low and sell high. Sounds simple yet few, if any, have been able to do it consistently. Most people tend to get caught up in a buying spree and invest when stocks are soaring, then lose nerve and sell out when they are sinking. For them, a more disciplined alternative could be dollar-cost-averaging. This is a simple strategy that appeals to conservative investors who want to take advantage of market growth to invest toward a long-term goal, such as retirement or a child’s education.
Dollar-cost-averaging simply means investing a set amount at regular intervals, such as $200 every month. After a period of time, say five years, you should own more shares than if you had invested the entire amount at the outset. This is possible because you will have purchased more shares when the market is low, fewer when it is high. For example, assume you invest $100 per month into a mutual fund. In February the price per unit is $10; March the price per unit is $5; April the price per unit is $7.50.
Contribution Price/Unit # of units bought
Feb $100 $10 10
Mar $100 $5 20
Apr $100 $7.50 13.33
TOTAL $300 43.33
At first glance it appears that you lost money ($10/unit in February vs $7.50/unit in April). You have invested $300.00 but the market value is $324.98 (43.33 units @ 7.50 per unit). This approach allows you to buy more when they are on “sale” and ensures you do not overbuy when they are overpriced.
Dollar-cost-averaging, which is similar in concept to a disciplined savings program such as payroll deduction works especially well with mutual funds, but not as well with individual stocks. Mutual funds allow you to invest small amounts and your risk is spread over a number of securities. Stocks, on the other hand, normally are sold in lots of 100 (a board lot), often requiring a purchaser to invest more or less than the planned monthly payment. Breaking a board lot incurs a premium that diminishes the effectiveness of dollar-cost-averaging.
Dollar-cost-averaging is essentially a defensive policy that is most effective in a market that fluctuates over a prolonged period. Dollar-cost-averaging takes the guesswork out of investing. Because it is a long-term program, the strategy is appropriate for retirement plans. Accumulating shares in a common stock fund within an RRSP is likely to be a rewarding long-term strategy no matter what the stock market does.
Dollar-cost-averaging makes sense if you want to build assets at a lower average cost, as this strategy almost assures you that you will acquire more shares, while reducing much of the market-timing risk, too. But, as with any investment, you must still choose and monitor your stock, mutual fund or other investment carefully. As C. Hillis said, “It’s not the bulls and bears you need to avoid it’s the bum steers.
Rick Turgeon, BBA, CA, CFP is president of the RRSP, investment, life insurance and estate planning firm of Turgeon Financial Inc. Comments or questions can be emailed c/o firstname.lastname@example.org