Averaging Down Never Looked So Good

By Will Ashworth | November 19, 2009 AAA

Almost one year ago to the day, I was discussing the hopelessness of the markets with a fellow writer. He provided me with evidence showing the best yearly returns for U.S. stocks in the last 100 years. Most of the winners came the year after a recession. That got us wondering if the big year would be in 2009 or 2010. Wilshire Funds offers a product that tracks the Wilshire 5000 index. It's up 23.73% year-to-date. A great result, but definitely not record breaking. Perhaps 2010 will be even better. I suggested to my writer pal that since it was clearly impossible to pick the sectors and industries that would outperform going forward, the best course of action would be to buy the index on a monthly basis until it appears the bull is dead. Hindsight sure is 20/20.
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Looking Back
If you bought an equal amount of the fund monthly between December of last year and November this year, your return would be 20.6%, 530 basis points less than if you'd simply bought the one time. However, as I've already mentioned, hindsight is what it is. A more interesting alternative would have been to buy once in December and then every month where the fund dropped in value. Using the average monthly price, your return would be 26.9%, 630 basis points higher than simply dollar-cost averaging each month or alternatively, 100 basis points better by investing one large sum into the fund back in December. Any of these three was better than being out of the markets for the last year.

Moving Forward
This is where it gets tricky. Stocks are getting expensive and each subsequent increase in the indexes only makes it tougher to commit to 2010. Could we see returns of 50% in the coming year? Sure we can, but that doesn't mean we will. The scenario above simply illustrates how investors can play uncharted territory without losing their shirts. It especially helps if you have a long-term horizon and don't need the money immediately. Now let's move into actual stocks.

Core Fore Investing
If you've read anything by John Reese, CEO of Validea.com, you're likely familiar with his model portfolios. Using the investment principles of Warren Buffett, Peter Lynch and others, Reese cobbles together 10- and 20-stock portfolios. According to Reese, this is the sweet spot. More than 20 are simply too many. Others espouse the core holding theory whereby certain quality stocks form a solid foundation for the rest of your portfolio. I've come to believe in a combination of the two theories, what I call "Core Fore Investing." These are 16-stock portfolios possessing four components, each holding four stocks, one for every market cap. I've found this provides good diversification and less exposure to risk while maintaining attractive returns. To illustrate, I'll use the one-year time period referenced above taking a component from one of my recent articles.

One-Year Performance

Company Market Cap Return Without Additions Return With Additions - Monthly Return With Additions - Price Drop
NovaMed (Nasdaq:NOVA) Micro 18.2% 16.6% 27.9%
Dominos Pizza (NYSE:DPZ) Small 92.7% 2.5% 5.2%
Snap-On (NYSE:SNA) Mid 11.1% 20.6% 28.5%
National Oilwell Varco (NYSE:NOV) Large 61.4% 39.6% 44.5%

45.9% 19.8% 26.5%
Wilshire 5000 Index Fund

25.9% 20.6% 26.9%

Once Is Enough
It would be wonderful to live in a world where market timing is possible, but no such world exists. Hanging your family's financial future on a hunch is simply poor judgment. How many times in your lifetime can you expect to get into the market at precisely the right time? Once or twice ... if you're lucky. Then what do you do for the rest of the time? For those who don't have the time or inclination to pick individual stocks, buy the Wilshire 5000 index at the end of every down month (the monthly amount is up to you) and stick to that plan for 10-20 years. You'll do more than fine. For those who believe that stock picking can make a difference, the same theory applied with stocks works equally as well. Just remember to build your foundation wide, but not too wide.

Bottom Line
My illustration does a decent job of demonstrating the strategic application of indexing. While I believe, like Mr. Reese, that a good, carefully selected portfolio will outperform the markets long-term, there's little doubt that indexing works, especially when you average down. (For more, see Averaging Down: Good Idea Or Big Mistake?)

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