Reduce Your Risk Of Buying High

01/24/01 05:39:15 PM PST

by David Penn

Dollar cost averaging is one way to make sure you're not getting into the market at too high a price.

Whether you have a lump sum to invest or simply use a small portion of every paycheck to build your portfolio, dollar cost averaging can help you deal with the one question that often haunts investors: when do I get in? Given the fact that most everyone who even contemplates investing in the stock market -- whether by purchasing individual stocks or buying shares in a mutual fund -- is familiar with the adage Buy low and sell high, trying to figure out when the market or a particular stock is at a true low can be a paralyzing experience. But by investing a set amount regularly and judiciously, you should end up buying shares cheaper than you might have by deploying all of your financial resources at once.

AVERAGING IN ACTION
As an example, say you receive $20,000 as part of an inheritance (or even better, as the result of a winning lottery ticket) and you decide you're finally ready to invest your money. Wanting to play it relatively safe and knowing little about stocks, you decide to opt for mutual funds. While your knowledge about stocks is limited, you do know you will get more for your money if the market is down when you buy as opposed to if the market is up. Not only that, you pay enough attention to the news to know the market has been doing very well over the past few years. So instead of blithely sending off a cashier's check for $20,000 to your chosen mutual fund family, you decide to send the mutual fund a portion of that $20,000 once a month until the entire amount is invested.

Figure 1 shows how many shares of Vanguard Growth Index Fund (VIGIX) could have been purchased using a dollar cost averaging strategy from July 1999 to July 2000. The middle column lists the net asset value (NAV) of the fund's shares each month, while the right column lists the number of shares purchased. If our investor were to use dollar cost averaging to invest his or her $20,000 over 12 months, he would have had $1,666 available each month to purchase shares from Vanguard Growth Index Fund.

FIGURE 1: DOLLAR COST AVERAGING STRATEGY. Here's how many shares of Vanguard Growth Index Fund could have been purchased using a dollar cost averaging strategy from July 1999 to July 2000. The middle column lists the net asset value of the fund's shares, and the column on the right lists the number of shares purchased.

Note how both the net asset value and the number of shares bought change through the months. When the net asset value is higher, the number of shares purchased decreases because shares are more expensive as the value of the fund rises. Conversely, when the net asset value is lower, the number of shares that can be purchased increases.

Had our hypothetical investor used all of his $20,000 at once instead of deploying dollar cost averaging, he might not have been able to purchase a larger number of shares for the same money. As Figure 1 shows, it would have depended on when the investor made the $20,000 buy. Spending all of it in September 1999 would have provided the investor with 595 shares -- 56 more shares than through a dollar cost averaging strategy beginning in July of that same year. However, had he invested all $20,000 in March 2000, he would have ended up with 488 shares in the fund -- 51 shares less than the dollar cost averaging strategy shown.

Dollar cost averaging is essentially a money management tool. While other investment strategies are geared toward maximizing profits in the stock market, money management strategies like dollar cost averaging are geared toward minimizing the risks inherent in investing in the stock market. In particular, dollar cost averaging helps minimize market risk, which addresses the possibility of equity prices moving against the intentions of investors due to the interplay of buying and selling forces.

VALUE AVERAGING
One variant of the cost averaging approach is called value averaging. Dollar cost averaging works for investors with a large sum of capital to put into the market as well as those who invest smaller amounts on a regular basis (out of preference or necessity), but value averaging is used most often by experienced investors with a sizable amount to invest.

Value averaging involves increasing the value of a particular investment by a certain amount each period. Say an investor in June is looking to increase the value of his holdings by $1,000 every other month. If the value of his holdings in August has increased by $500, then the investor only needs to add $500 to make his bimonthly goals. If his holdings have increased by $1,000 or more, then the investor need not make any additional investment. Depending on the investor's goals, any amount above and beyond the $1,000 bimonthly goal may even be siphoned off as profit or used elsewhere.

However, if the holdings decrease in value, say losing $500, then the investor will need to spend $1,500 to remain on track. Value averaging can be useful for an investor looking to reach a certain financial goal and often requires a ready supply of cash for investment to guard against falling behind.

AVERAGING FOR ALL OCCASIONS
Even investors not sitting on a pile of cash can take advantage of dollar cost averaging by setting aside a certain amount each month to buy additional shares in a fund. Using dollar cost averaging has the additional benefit of helping investors become and remain more committed to a long-term investment program. After a few months of sending off the monthly or quarterly check to the mutual fund company, dollar cost averaging becomes as much second nature as the monthly credit card bill or the quarterly insurance payment. Whether you make large additions or small, dollar cost averaging is a way to make investing easier and, in the long run, perhaps more profitable, too.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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