Volatility and Market Fluctuations are Great for Retail Investors

In this tough economic environment, it’s only natural to feel unsecure about our money in the stock market.  It’s true that the economy is contracting, it’s a fact that unemployment is rising and it’s pretty much a guarantee that housing prices will continue to go down.  However, I’m still going to tell you to continue investing now.

Invest Now When it’s So Volatile?

Sometimes perception can ruin our wealth.  Consider a simple example:
Investor A (we will call him “Lucky”) began to make a $500 monthly investment into the stock market as the market soared.  In fact, the market kept going up without fail for the next 6 months.  Perfect timing right?

Investor B (let’s call him Joe) on the other hand picked a different timeframe (much like the times currently).  With the same investment of $500 per month, he bought into the market as it went down for the first three months, then back to its original price after six.

The following chart could very well illustrate the stock prices for the six months they were invested.

fluctuation example
In this example and considering that both Lucky and Joe invested $3,000, which investor came out ahead?

In the 6-month bull market, Lucky accumulated 24.90 (6.25 + 5 + 4.17 + 3.57 + 3.13 + 2.78) shares.  With each share valued at $180, his investment increased to $4,482.  Not bad for timing the market right.

Now let’s take a look at Joe.  With his luck and timing, he ended up buying 74.29 (6.25 + 10 + 14.29 + 25 + 12.5 + 6.25) shares.  With the price being $80 a share, his investments are worth $5,943.20 after six months!

The Power of Dollar Cost Averaging in a Volatile Market

In our simple example, Joe was able to accumulate many shares at a very low cost.  He believed that while he can’t predict the bottom, prices would eventually be on the upswing again.  As he saw prices drop further, he continued buying into the market, trusting the math and reading about how to not lose sleep in a bear market.  As it turns out, he was one of the few people who benefited from the market downturn.

This simple but powerful example illustrates why you should continue to invest in the market.  No one knows when the bottom will occur, but if you keep investing, you will be able to accumulate shares at incredible prices.  Once prices start to rise again, you will be able to take advantage that much more.

A Few Words of Caution

Before you go off buying securities, make sure you understand these few points as it can help avoid disaster.

  1. Diversification – I hear about dollar cost averaging when buying a stock all the time.  This example is not for individual stocks.  Guess what happened to people whom dollar cost averaged into Lehman Brothers?  When you keep buying a stock, you are betting that the company behind it will be able to turn around eventually.  When buying into an index like the S&P 500, you are betting on capitalism bringing back prosperity.  The latter is much safer don’t you think?
  2. Holding Power – The key to the success of dollar cost averaging is time horizon.  How soon do you really need the money?  If Joe needed his money on the 3rd month, he wouldn’t do so well.  The stock market can continue to go down for months, if not years!  Don’t invest any money you need in the short term and expect dollar cost averaging to always work in your favor.
  3. Automatic – It’s too difficult for most people to put money into the market when bad economic news are everywhere.  Dollar cost averaging almost only works when you put your contributions in automatic mode so set it up right now and forget about it!

If you are on the sidelines and contemplating when you should get back in the market, now is the perfect time.   Continue investing, because prosperous times will return eventually.

More on this topic (What's this?)
Market Volatility In Perspective
High Beta Underperforming Low Volatility
Read more on Historical Volatility at Wikinvest

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{ 3 comments… read them below or add one }

ObliviousInvestor May 19, 2009 at 9:39 am

Excellent points! DCA’ing downward into an individual stock is a risky proposition. DCA’ing downward into a broadly-diversified index fund is far less scary. :)

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Ross May 19, 2009 at 11:27 am

Great post! I wish people would just stop taking money out AFTER the market crashes and buy them back AFTER the market does well. Sigh. Hopefully they will learn some day.

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Ethan May 20, 2009 at 8:00 am

Technically this might not be dollar-cost-averaging. DCA is what you do when you have a lump sum and decide to buy into the market slowly rather than invest it all at once. While somewhat more conservative, on average this is a losing move. Buying in today is better than buying in tomorrow, on average. Unless you are highly concerned about the market’s immediate future, it’s not necessarily a great idea.

Instead your two examples were probably exercising automatic investing – investing new wealth as they earned it and without regard for market direction. That is a *great* idea and brings about good results over the long term. There’s a lot of data out there about how DCA is a bad idea, but it’s all based on the notion that you have a choice to invest today, but decide to spread it out instead.

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