When investing, it is important to pick stocks, ETFs, or Mutual funds that are positioned to do well given major trends and company/fund specifics. Another important factor, which doesn't always get a lot of attention, is developing a good method for averaging into a position. Many people might just outright buy at market, without giving much thought to the downside pressures that may exists for a certain stock or ETF. Since there are so many factors, the best way to "hedge" against the unknown is to buy in chunks, and on price weakness. This can help you capture gains early, and will let you sleep MUCH better at night. Trust me on that one! I am currently cleaning up a mess I made by NOT averaging into several positions. I thought I could pick the bottom and still sleep at night if I was wrong. Answer: No.
Dollar cost averaging, or buying in tranches, is one of the most effective ways to purchase stocks, Mutual funds, and ETFs, and it almost doesn't matter how much money you have to work with. More on the "almost" later. It does require some patience, but think about this: Stock XYZ is selling for $15, and is off it's highs of $20, so you buy a tranche. If you threw everything at it, and the stock fell to $13, you might start panicking, or get stopped out of the position if you use a trailing stop. However, if you only put 20%-25% of you desired position down, and the stock falls to $13, you would probably buy another tranche - that is, another 20%-25%. Then, if the stock fell again to a price you felt was ridiculously low, based on your research (we'll say that $9 for our example stock is undervalued), you would throw the remaining 60% of allotted cash into the mix.
Now if you had simply put everything in all at once, you would either have gotten stopped out of the position, would have sold in a panic, or would just be substantially down and probably worried. But by buying in tranches, you are actually now well positioned to take profits early into the stock's move up. If the stock pays dividends, you are doing even better, because you'll also have been collecting some cash while you wait (or in some cases, your dividends can be automatically re-invested through a DRP -- without commission).
With that, here is a spreadsheet I designed to (hopefully) illustrate the effectiveness of dollar cost averaging. I compare several methods using different portfolio assumptions. For example, a portfolio with 20k in capital vs a portfolio with 10k in capital. Look below the spreadsheet for some further explanation.
Sheet one shows everything with fairly high transaction costs ($28.95 per trade), and sheet two shows the exact same data, but with low transaction (discount) costs of $9.99 per trade.
Dollar cost averaging, or buying in tranches, is one of the most effective ways to purchase stocks, Mutual funds, and ETFs, and it almost doesn't matter how much money you have to work with. More on the "almost" later. It does require some patience, but think about this: Stock XYZ is selling for $15, and is off it's highs of $20, so you buy a tranche. If you threw everything at it, and the stock fell to $13, you might start panicking, or get stopped out of the position if you use a trailing stop. However, if you only put 20%-25% of you desired position down, and the stock falls to $13, you would probably buy another tranche - that is, another 20%-25%. Then, if the stock fell again to a price you felt was ridiculously low, based on your research (we'll say that $9 for our example stock is undervalued), you would throw the remaining 60% of allotted cash into the mix.
Now if you had simply put everything in all at once, you would either have gotten stopped out of the position, would have sold in a panic, or would just be substantially down and probably worried. But by buying in tranches, you are actually now well positioned to take profits early into the stock's move up. If the stock pays dividends, you are doing even better, because you'll also have been collecting some cash while you wait (or in some cases, your dividends can be automatically re-invested through a DRP -- without commission).
With that, here is a spreadsheet I designed to (hopefully) illustrate the effectiveness of dollar cost averaging. I compare several methods using different portfolio assumptions. For example, a portfolio with 20k in capital vs a portfolio with 10k in capital. Look below the spreadsheet for some further explanation.
Sheet one shows everything with fairly high transaction costs ($28.95 per trade), and sheet two shows the exact same data, but with low transaction (discount) costs of $9.99 per trade.
You can see in Method 1 that with $2,000 of capital, averaging in with tranches that roughly correspond to 20%, 20% followed by a final 60% allows you take profits at a MUCH lower prince than if you simply put your 2000 down in one 'chunk'. The reason is that as the price declines, you are able to buy more shares with the same amount of capital. Then as the price rises, the shares you bought cheaply overwhelm your first two tranches, and you start to see profits early. I would try buying a first tranche at what seems to be the bottom of a security's trading range, and then buy more tranches with each 15-20% decline from the price you bought in at.
But as you can see, with high transaction costs, you will want to minimize the number of tranches you buy - which means you must pick your entry points carefully. Method 4 can only be used with low or no transaction costs.I chose to include the higher transaction costs in my final price of the stock (meaning: what I paid to take a position), because we don't want to put more than 5% (including transaction costs) of our entire portfolio into one stock.
With a very small amount of capital (say if you are starting with 10k), then it might be prudent to begin with sector ETFs or mutual funds. Decide how much you want to put into a sector as a whole (say, 15% - 30%- rather than 5% x 3 individual stocks). This would allow you to utilize Method 3 really effectively, and you would avoid the pitfalls of Method 4.
With the example of Gold, you could keep at least 5% of your total portfolio in physical gold, and put the other 25% into a gold miner's ETF or a gold miner's mutual fund, averaging in over 3 tranches.
If you are starting with an extremely small account (say, less than 10k), or from scratch, consider high quality, low-load or no-load Mutual Funds until you have build up enough capital to venture into stocks and ETFs. Stocks and ETfs require you to pay commissions when you buy shares, but if you are prudent in your research, you can avoid paying any commission buying and selling mutual funds. Remember though, that there is usually a penalty for 'trading' a mutual fund, so ask questions and find out! Do some research to find how how well the fund you want is managed, and consider low management fees, morning star ratings, distributions, as well as the top 10 - 25 holdings.
Until next time ...
R
