A common mistake that investors make is in believing that a down market is always bad. This is only true if you are selling. For those in the accumulation phase, a down market actually represents opportunity. How sad it is to hear about the investor who has been building his portfolio only to find that it has declined significantly during a market downturn and then he makes the critical mistake: he sells.
“After all,” Bob reasoned, “I need to cut my losses. I’ve been investing regularly into this mutual fund that supposedly had a great track record, and it’s gone down more than it’s gone up. In fact, my account is actually worth less than what I invested!” Bob had been building his portfolio with the discipline of regular monthly investing via his company 401(k) plan, but he lacked an understanding about the nature of investment markets and how to benefit from their fluctuation.
The goal is to buy low and sell high. And yet in a moment of panic, Bob sells low, the exact opposite of what he intellectually knows to be the prudent course of action. Why is it that intelligent people make such mistakes? Perhaps it’s because of greed and fear. We all know about buy low, sell high. But because of our emotions, we may take the wrong actions. How sad for Bob: he exited the market at the very moment when it was “the best of times,” the time of opportunity—the time when share prices were “on sale.”
It was a time to be celebrating, not panicking. Sometimes all it takes is access to wise counsel to help us stay the course and keep us focused on the basic principles of investing—one of which is dollar cost averaging, a simple mathematical phenomenon that actually capitalizes on market fluctuations.
Simply stated, dollar cost averaging (DCA) is the act of placing the same number of dollars into the same portfolio of securities at regular intervals—for example, investing $1,000 per month into a balanced mutual fund. Because the number of shares that can be bought for a fixed amount of money varies inversely with their price, DCA leads to more shares being bought when their price is low, and a smaller number of shares when they are expensive. As a mathematical result, DCA causes the average cost per share of the investments purchased to be lower than the average purchase price of those same shares.
At this moment, you’re probably asking yourself, “What? How can that be?” The best way to come to an understanding of this phenomenon is go to each of the following examples where you will play an investment game: