SUPPOSE YOU STASH $400 each paycheck in your employer’s 401(k) plan. Whether you know it or not, you’re engaging in dollar-cost averaging. A good idea? Saving on a regular basis is a great habit to get into. But despite what some folks suggest, it’s neither magical nor a sure way to make money in the markets.
To understand the purported magic, imagine your regular $400 investment goes into a stock mutual fund. Your first investment is at $10 a share, which means your $400 buys 40 shares. The market promptly plunges 20%, so your next $400 investment buys 50 shares at $8 apiece. You now own a total of 90 shares.
Over the weeks that follow, the market partially recovers, so your stock fund’s share price rises to $9, halfway between your two purchase prices. But at $9 a share, your 90 shares—for which you paid $800—are now worth $810. Magic? Not at all. You ended up with a profit simply because you invested a constant dollar amount, so you bought more shares when the price went down.
Suppose, instead, that you focused on regularly buying 40 shares. You would have invested $400 when the share price was $10 and $320 when the price was $8, for a total of $720. What happens when the share price bounces back to $9? Your 80 shares would be worth $720, the same as the amount you paid.
In other words, dollar-cost averaging works because it’s a slightly contrarian strategy, where you buy more shares when the market goes down. For the strategy to work, the investment needs to recover from any price decline. That is a reasonable bet with a diversified stock mutual fund, but it may never happen with an individual stock.
If a slightly contrarian strategy pays off, what if you were even more contrarian? That’s the thinking behind value averaging.
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