As of February 28th, the stock market lost about 10 percent of its value. While the news channels proclaimed the impending doom of the stock market and every fool who hasn’t yet run for the hills, I noticed many investors are seemingly excited about the market calamity.
Do they know something we don’t?
Yes, and no. No, they do not know exactly what the market is going to do. If they did, I’m pretty sure they would be somewhere sipping a coke with Warren Buffet.
But what they DO know is this…the stock market goes through value swings on a regular basis. Every time, analysts declare that “this time is different”. It’s not. The market always recovers. In fact, since 1930 the Dow Jones has increased in value an average of 10 percent a year. There are bear markets and bull markets, upswings and downswings, but it moves steadily in an upward trend over time.
So how can We take advantage of this?
The answer is Dollar Cost Averaging. By purchasing shares of a stock or fund on a regular basis, you can negate the effects of market swings over the long run.
Let’s imagine you bought a share of a fund for $50. The very next payday, you buy another share but this time the market price has gone up and it’s now $55. Your total portfolio value is $105 and consists of 2 shares at a dollar cost average of $52.50 (50+55 / 2 shares).
Now imagine that the stock market tanks! You look at your portfolio and instead of a total value of $105, your portfolio now shows only $75. While it looks like you lost money, only the value of your shares has changed. Instead of the market price of $55, it is now at $37.50 a share. But, you STILL have the same number of shares. Remember, you don’t actually lose money until you sell your shares.
This is the point where some people panic. Don’t be that person.
What you are seeing in your total portfolio value is the difference between the current stock price ($37.50) and your dollar cost average ($52.50). You still have 2 shares of the stock, and once the stock price returns to $52.50, your portfolio will return to the original value of $105.
Now, back to the reason some investors are happy about the market drop. Savvy investors look at negative market swings like most people look at a huge sale at a department store. They salivate as they look at all the stocks they’ve been coveting over the past few months but were too expensive. Now they can purchase them at a discounted price. You’ll often hear them tout the phrase “Buy the dip!” all over social media.
Let’s use the imaginary scenario from before as an example.
After your savvy investor friend talks you off the ledge and explains the idea of dollar cost averaging, you decide to go ahead and purchase more shares instead of selling. You purchase two more shares at $37.50. Now you own four shares and your dollar cost average is $44.75 (50+55+37+37 / 4 shares). Now, your portfolio will be back in the positive once the stock value reaches $44.75 vs before at your old dollar cost average of $52.50. Every time you purchase at a lower price it goes down and vice versa when the market is up. Hence the saying, buy low – sell high.
That’s how dollar cost averaging works. Now, if you maintain this strategy over the course of many years, your portfolio will be able to withstand the market fluctuations that will inevitably come. And then you can be the savvy investor talking your friends off the ledge while you explain the magical powers of dollar cost averaging.
If you would like more information before you begin investing, check out my article entitled, Before You Start Investing.
