Now, today's topic.
There is a lack of appreciation and understanding of the ability to reduce risk through dollar cost averaging. Taking the worry out of one's life is a reasonable objective, and as long as we are comfortable with our investment selections, we may move things to the next step with blind dollar cost averaging. First, though, we'll need to understand how risk reduction is obtained.
Dollar cost averaging occurs when one makes numerous stock purchases of the same company over a period of time. This is differentiated from what I refer to as an "outright purchase," which happens when one places a single large amount into the purchase of a company.
When one makes an outright purchase, the cost of the share becomes the all-important criteria. If the price of the stock drops, the value of the position drops and the buyer hopes for a quick rebound. When the price rises, the value of the investment increases, much to the delight of the buyer.
As one is placing a great deal of faith in a single judgment, the risk is the greatest. What would happen if after deciding to purchase a company's stock, we bought half of the position immediately, then made the other half at a later time? If the value dropped, then our subsequent purchase would halve the loss. For instance, if the initial purchase was made at $100 per share and the other half at $90, our cost basis for the position would be $95. It would be as if we had made the entire purchase at $95, not $100.
Of course, this works the other way, too. If the price of the stock moved up and we made the second purchase at $110, it would be as if we had made the entire purchase at $105.
This is where the element of risk comes into play. In the situation where we made a single purchase, the movement of the price 10% either way caused the value of the purchase to move 10%. However, when two purchases are made 10% apart, the movement of the cost basis is only 5%. The greater the risk, the greater the potential for gain or loss.
From this we can see how making over a hundred purchases during the course of a decade works to reduce risk, as far as the cost basis is concerned. Not only is risk reduced, but the problem of sleepless nights due to worrying about the wisdom of those purchases is subdued. Of course, your returns may be subdued, too, if the market's general trend is up over the period. However, your returns may be helped if the stock is going down as you're buying but rebounds later.
So, how do we take this to the next step -- or better yet, should we take this to the next step? It is entirely reasonable that some individuals would rather concern themselves with issues outside of their financial situation. I know that with Baseball season imminent, I will be turning my attention to other things. So how can this be accomplished?
The simple answer is blind dollar cost averaging. This is really another term for the harder-to-remember "automated clearing house" means of submitting funds. Usually abbreviated as ACH, this involves telling the Drip's transfer agent that you wish to make the same dollar-amount purchase each month, and that you wish to have the funds transferred automatically from your bank account. This becomes a "set and forget" means of investing.
The only caveat here is that some companies that otherwise offer fee-free Drips charge for this service. This never made sense to me, as it certainly costs the company more to process a paper check than it does to electronically transfer funds.
For an explanation, I asked Susan Shaw, corporate secretary for the Coca-Cola Company (NYSE: KO), at the 1999 shareholders meeting. Her explanation was that it was one of the few ways that Coke could recoup some of the costs of offering their Drip plan without fees. Since the majority of registered shareholders of the company hold their shares within their Drip, the cost for the maintenance of the program must be enormous.
So as spring arrives and one's mind turns to other delights, one may make a "quality of life" decision to allow their investments to work for them through a reduction of risk and blind dollar cost investing. There are so many other things going on, it's nice to know that this option is available.
Next week we will look at variations on the blind theme. To discuss this column specifically, or ask questions, please visit the Drip Basics board linked below.