Why smart investors keep buying when markets fall
Here's a phrase only a boffin could make up: 'dollar-cost averaging'. It kind of feels like some sort of tax calculation or a phrase accountants would use, right?
I should make it my aim to come up with a better term. But I'm a finance nerd, not a creative genius, so instead, I'll give a Freddo Frog to anyone who can come up with a better one. Especially because it's a really important idea that will not only help you build long-term wealth, but also ride the waves of volatility.
Here's the idea.
Previously, I've talked about saving money every payday, and investing that money as regularly as you can (keeping costs low as you go).
Let's use a hypothetical example.
You decide to invest every month. In the first month, the shares are $9 each. Next month, $10. The month after, $9.50. Then $11, $10 and $10.50.
At the end of six months, that $10.50 price is higher than some of the prices you paid, but lower than others. But what if you'd bought only once? Maybe you'd have paid $9. At the end of that six-month period, you'd have made a nice gain and probably feel pretty good.
And if you'd only bought once, say, in month four? You'd have paid $11, and be nursing a small but disappointing loss.
Smooth sailing
Now, in an investing lifetime, one company, bought once isn't going to make or break you. Even buying a few companies a few times won't.
But if you're making only very occasional, large purchases, you're putting a lot of store in your ability, or luck, to buy for the right price at the right time.
Dollar-cost averaging, by comparison, suggests that buying small amounts regularly smooths, or 'averages', your cost. Hence the (clunky) name.
It removes the need to try to time the market, by giving you an average(-ish) price.
Let's say you invest $200 per month for a year. Sometimes the price is up. Sometimes it's down. It'd be nice for the share price to just go up after you bought, of course, but there's something else at play here. Just look at how your purchasing power expands when the price falls (see table, opposite).
No-one likes a smaller portfolio. But because you keep buying, in the 'down' months you get more shares for your money!
You own more of the company now than if the share price had simply only gone up.
On the straight and narrow
Here's the other way to look at it through a behavioural psychology lens: if you buy today at $10, and the share price drops to $9, you get to buy the next lot at a cheaper price. And if you buy today at $10 and the share price rises to $11, you've made money.
Now, that's selective use of data and arguments, of course, but the point is that it helps keep us on the investing straight and narrow, and keeps us buying.
See, I've heard plenty of people take one of two opposing views based on how they feel about share price movements.
When a share price falls, some people will say, 'Great, it's cheap. I should buy more', while others will say, 'Nah, it's falling... I'm not buying'.
On the other hand, when prices rise, some worry that 'I've missed it', while others say, 'It's going up... I'll buy'.
I'll level with you: None of those approaches is right, based only on share price movements.
Maybe the stock that's gone up is now too expensive. Maybe the one that fell is down because the business is tanking. Or maybe the shares are up because the business is growing strongly, or down because of sentiment, not business reality.
In other words, there is nothing to learn from past share price movements!
But dollar-cost averaging, when committed to as a strategy, allows you to put those psychological demons to rest. It allows you to make your investing more mechanical, adding regularly as long as the company is worth investing in at the current price.
It won't give you the lowest price ever, but then nothing other than luck will ever do that.
And you could be more involved if you wanted, picking which company's shares you buy when, if that's your preference.
But for many, perhaps most, people, dollar-cost averaging is a form of the 'pre-commitment'. And it can be a serious help when it comes to getting invested, remaining invested and adding to your investment snowball as it rolls steadily downhill, picking up more snow as it goes.
Now, let's unpack one of the most powerful acronyms in investing.
The Pareto Principle
You might have heard of a bloke called Pareto, after whom the Pareto Principle is named. You've almost certainly heard his idea expressed more simply as the 80/20 rule.
The idea is that 80% of a result comes from 20% of the effort. Maybe 20% of a company's customers deliver 80% of the revenue. Maybe 20% of a company's customers are responsible for 80% of complaints, too!
(Apparently, or apocryphally, Pareto discovered that 80% of the peas he got from his garden came from 20% of the plants!)
You get the drift. It's commonsense, and a concept that you probably have personal experience with, even if you didn't consciously think about it as the 80/20 rule.
It won't surprise you to learn that the same thing applies, directionally at least, Pareto is essentially a rule of thumb, in investing.
Except it might be closer to 90/10 or 95/5.
The vast bulk of your return will be driven by your savings rate and investing horizon. A little extra (the 5%, 10% or 20%) might come from the time, effort and energy you put into trying to outsmart the market.
Maybe.
The Pareto Principle isn't an iron law, but it is an observation that getting a few big things right is generally the key to success in most endeavours.
In investing, that's probably your savings rate, your investment horizon, diversification, dollar-cost averaging and patience.
By all means, chase the extra return if you have the opportunity... just make sure it doesn't backfire on you, instead.
What really matters
Complex strategies rarely outperform simple, disciplined approaches.
Diversification and consistency matter far more than cleverness.
Simplicity makes investing easier to stick with when markets become volatile.
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