DCA: It Gets You In At The Bottom

by Cory Janssen, Co-Founder, Investopedia.com (Contact Author | Biography)
Today we're going to let you in on a hot tip for surviving a sinking stock market.

Industry players and pundits try to convince us that they can tell when the market will hit bottom. Knowing who to believe is just as difficult as it is for them to actually pick the bottom! What's an investor to do? In this article, we’ll explain a little-known technique that will help protect you in a falling market and let you ignore the futile attempts of those who think they can predict the market's behavior. There is only one proven investment technique that, regardless of economic conditions, can consistently get investors in at the bottom. Read on to find out what it is, and why it is important.

What Is the Bottom?
When a security or market sinks to its lowest price level in a given time period, it means they have hit bottom. Whenever the markets plummet, people get excited about getting in, but they want to do so only after securities have bottomed out - when price levels begin a steady rise after hitting bottom. Since everyone wants to know when that will happen, CEOs, media types and analysts all try to forecast the upturn, which signifies that the bottom has indeed been established. Because no one wants to be the last to call the bottom in case price levels tank further, we are bombarded with confidence-building words from every level of industry, including the industry watchers, that prices are unlikely to continue their downward trend.
Much of this commotion comes from the "buying on the dip" mentality left over from the previous bull market in the 1990s when many made a lot of money buying cheap at every dip and riding the recovery. On the other hand, investors in a bear market feel "things can't possibly get any worse" and that "logically" the market can only climb up.

The Game
Calling the bottom has become such a worldwide pastime - it would make veteran investors like Warren Buffett, John Bogle and Peter Lynch chuckle (read more about these great investors here) - you'd think there was a cash prize for predicting it. To illustrate, here are a handful of past bottom calls as well as the figures that followed.The Way In The truth of the matter is that if hedge fund managers, mutual fund managers, private investment managers, market gurus, CEOs and analysts can't pick the bottom, neither can we. But don't despair, there is a means to protect yourself in the long run from the effects of a bear market as well as ensure your injection of capital into the market when it is extremely close to the bottom.

The technique is called dollar-cost averaging (DCA), and it is one of the simplest and most useful investing techniques around. DCA is simply putting a set amount of money each month into an investment such as a stock, index fund or mutual fund. Most banks will even set up a monthly automatic-withdrawals service. DCA is also ideal for the investor who doesn't have that big lump sum at the start but can invest small amounts on a regular basis.

Why DCA Is So Effective? The markets, even though they have bad days or even bad years, tend to go up over time - during the past century, U.S. equities markets appreciated each year by a near 11% average. When you invest a set amount of your money each month, you buy fewer shares when the market is high and more shares when it's low. For example, your fixed investment might buy 10 shares when the price is low and only five shares when the price is higher. DCA therefore lessens the risk of investing a large amount in a single investment at the wrong time (i.e. at an inflated price), and in a falling market, the average cost per share becomes smaller and smaller. This lessening average cost per share will help you gain better overall profits as the market increases over the long term.

Example
Let's suppose that you just got a bonus and now have $10,000 to invest. Instead of investing the lump sum into a mutual fund or stock, you decide to use dollar-cost averaging and spread the investment out over several months by investing $2,000 a month for the next five months. This averages the price over five months, so some months you may buy fewer shares, each at a higher price, and some months you may buy more shares, each at a lower price.
If the market is lower this month, you may lose money on the shares you bought last month, but this month you receive more shares, which, in the future, will help offset any losses. With DCA, you are able to take advantage of any low during these five months, guaranteeing you to invest at the very bottom because when it comes, you are simply doing what you do every month. Once the market turns around, which it is likely to do in the long term, you'll be ahead. The best part is you didn't have to do any predicting! If you were to try to forecast the bottom, you could miss it altogether and risk putting your entire $10,000 in at a bad time.

What About Timing?
Many people ask, "Isn't it more profitable to buy as much as you can when the market is at its lowest and sell everything when it is at its highest?" Of course it is, but any professional investor will tell you that you pretty much need supernatural powers to get a correct prediction. No one knows when the bottoms and tops will happen exactly, and no one can stop surprises from happening. This is why so many professionals preach dollar-cost averaging as an optimal strategy regardless of what the market is doing: DCA smoothes out the bumps of the market over the long term.
Conclusion
Next time you hear of a forecasted bottom, you can be confident that he or she is no more insightful than you no matter who the individual is. No person can predict market behavior. But you can be rest assured that if you use dollar-cost averaging, you are being prudent. DCA not only offers protection from market swings but also helps you can take advantage of the ever-elusive market bottom.

by Cory Janssen, (Contact Author | Biography)

Cory Janssen is a co-founder of Investopedia.com and currently oversees the company's internal operations.

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