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The Smart Strategy for Scared Investors

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In uncertain times, many investors want to hedge their bets. Even if you have money to invest, it's natural to wonder whether you ought to be putting a big chunk of cash into the market right now, versus waiting and potentially scoring a bigger bargain in the near future.

One strategy, dollar-cost averaging, is designed to try to give you the best of both worlds. But dollar-cost averaging has its downsides as well. So if you're saving money regularly to invest, what's the best strategy to follow?

Answering the big question
That's what @natemcgraw asked the Fool on our Twitter feed: "Better to dollar cost average with monthly (or so) buys or to save up for a bigger buy when you think the price is right?"

Before tackling the question, let's quickly review what dollar-cost averaging is. Rather than taking a big lump sum and investing it all at once, dollar-cost averaging involves breaking that lump sum into several equal pieces, investing each piece one by one at regular intervals.

The strategy has two advantages over simply making a one-time investment. First, it protects you from having extremely bad timing with your purchase. If the market drops immediately after your first buy, you still have all the other pieces left to invest in the future. Second, if prices do fall, dollar-cost averaging benefits you; by investing the same dollar amount each time, you'll buy a greater number of shares when the cost per share drops.

Some investors have questioned whether dollar-cost averaging really makes sense, though. Historically, the stock market has trended up more often than down, and so you'd often have been better off simply putting your entire investment at the outset, rather than parceling it out.

A simple rule
Since there's no way to predict exactly whether a stock will rise or fall in the short run, coming up with an answer that universally works isn't possible. But one simple rule gives you a good starting point:

Use dollar-cost averaging if the stock you like has an above-average valuation. Buy shares all at once if the stock is undervalued.

To see how this works, let's take a couple of examples.

In the summer of 2008, commodity stocks had risen sharply. Prices of everything from oil and precious metals to foodstuffs and basic materials had jumped to all-time highs, and stocks in those industries performed extremely well. Fertilizer stocks PotashCorp (NYSE: POT  ) and Mosaic (NYSE: MOS  ) seemed poised for huge future growth, and Freeport-McMoRan Copper & Gold (NYSE: FCX  ) and BHP Billiton (NYSE: BHP  ) were among the many mining companies whose shares skyrocketed as worldwide demand for copper and other base metals went through the roof.

After such strong moves, you might have inferred that shares were valued fairly richly. With prices counting on near-perfection, you might have turned to dollar-cost averaging to protect yourself. As it turned out, that would've been the right move, substantially reducing your losses from what proved to be the worst timing possible.

Stock

Gain/(Loss) With Lump-Sum

Gain/(Loss) With 6-Month Dollar-Cost Averaging

PotashCorp

(73%)

(48%)

Mosaic

(79%)

(51%)

Freeport-McMoRan

(79%)

(50%)

BHP Billiton

(52%)

(27%)

Source: Yahoo! Finance. Returns are for period from June 2008 to November 2008.

In contrast, by early 2009, values abounded in the market. The victims weren't just speculative stocks like Las Vegas Sands and Sirius XM; even blue chips were bid down to extreme lows. Coca-Cola (NYSE: KO  ) saw the same low valuation that had enticed Warren Buffett to buy the stock 20 years before. Procter & Gamble (NYSE: PG  ) and Intel (Nasdaq: INTC  ) also suffered big losses, despite selling products that enjoy constant demand among consumers.

With stocks at good values, you should have been inclined to get your money in as quickly as possible. Again, that turned out to be the right thing to do:

Stock

Gain/(Loss) With Lump-Sum

Gain/(Loss) With Dollar-Cost Averaging

Coca-Cola

12%

4%

Procter & Gamble

17%

6%

Intel

37%

21%

Source: Yahoo! Finance. Returns are for period from March 2009 to August 2009.

Know what's coming
Of course, you won't always have perfect timing. Value stocks can go still lower, and high-priced stocks can keep rising.

But over time, using this mixed strategy should lead to better results than an all-or-nothing approach. That way, you can still bet big on your best investing ideas while maintaining a more conservative stance on stocks that have more risk.

Nothing's smarter than buying great stocks when they're inexpensive. Matt Koppenheffer knows about five stocks that are cheaper than you think.

Fool contributor Dan Caplinger averages with the best of them. He owns shares of Freeport-McMoRan. Intel and Coca-Cola are Motley Fool Inside Value choices. Coca-Cola and Procter & Gamble are Motley Fool Income Investor picks. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Coca-Cola, Intel, and Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy isn't afraid of the market, but still sleeps with a nightlight.


Read/Post Comments (2) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 15, 2010, at 1:44 PM, PeyDaFool wrote:

    I enjoyed this read quite a bit, Dan. I've long been a believer of using both DCAing and lump-sum investing.

    One thing I'd like to point out is I use DCAing for my Roth IRA and 401(k) while using lump-sum investing for my "fun" account. My fun account money is money I do not need for retirement, food, rent, etc., but rather money that's left over at the end of the month and is not vital to my survival.

    I'm a big advocate of DCAing for retirement, but I love to assess valuations and use lump-sums for the challenge and enjoyment of following Mr. Market.

  • Report this Comment On July 15, 2010, at 8:12 PM, DDHv wrote:

    We put cash into the account regularly. However, possible buys are arranged as limit buys from best company to worst company, current estimate. The best company price is closest to the current price, the worst is closest to the two year low price. Any week in which there are no buys, the price % of current-low is raised slightly. Any week when something buys, the price % of current-low is lowered. When cash is deposited, price% is lowered a bit. Given a rise, nothing buys. Given steady prices for long enough, the best company buys. Given a dip, there are multiple buys, starting with the best company and working down as far as the size of the dip determines. Size of the cash buy position for each company varies, with the best getting a minimum, and increasing in size as you go down to lower price%s.

    For selling, either a covered call is used, or a reverse of this procedure using 2 year highs and current prices.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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9/18/2014 4:06 PM
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