Finally, some new thinking about a basic investing strategy designed to calm nerves more than generate the best possible returns.
If you emphasize maximizing returns over containing risk, then invest lump sums of money when you have them. If you're haunted by the idea of investing a lump sum just before a market correction, then use dollar-cost averaging. DCA means making regular contributions to your investment account, usually on a monthly basis. Academic studies suggest lump-sum investments will generate higher returns over time, but DCA does shield you from investing large amounts at the worst possible moment. For many investors, this is a wise and fair tradeoff.
There may be a way around the tradeoff, though. It's called smart-dollar cost averaging and it was developed by Larry Berman of ETF Capital Management. Mr. Berman suggests buying into the market whenever a benchmark stock index is down 1.57 per cent or more. What he's done here is give investors a gauge to help them buy low. It's more stressful to do this instead of using traditional dollar-cost averaging, but Mr. Berman's data suggest the returns are better.
His analysis was based on a comparison of 60 month-end investments of $1,000 over the past five years versus slightly smaller amounts invested over the 64 days over the past five years where there was a decline of 1.57 per cent or more on the S&P 500.
The result was that smart-dollar cost averaging beat its traditional version by 18.9 per cent cumulatively over five years, or a little more than 3.5 per cent annually.
The drawback of smart-dollar cost averaging is that you have to be prepared to buy at the scariest moments for stocks. No doubt, there will be alarming headlines on investing websites and comments from strategists about holding cash and not "catching a falling knife." If you're going to freeze up at times like this, smart DCA won't work for you. You're better off sticking with traditional DCA and its regular monthly contributions. No worries here. Traditional DCA may not offer the best possible returns, but it is a sound strategy that helps keep nervous investors on track. In these nerve-wracking times, that's huge.