Despite overnight success stories you might hear about on the news and internet, the stock market is not a free-to-play, easily winnable game. Right now, when the market is rife with volatility, investing can be particularly intimidating.
Amidst double-digit drops in indexes and stock in large companies like Amazon, Alphabet and Tesla, the country has been plunged into a bear market . Tack on inflation, international tension and rising interest rates, and it appears that trouble could be brewing for those who invest in the market. There are, however, strategies one can adopt to mitigate some of the risk that comes with investment vehicles with downside.
When investing in stocks, indexes, ETFs or other market investments, two different strategies are typically employed: lump-sum investing and dollar cost averaging. Choosing one can depend on your goals, the diversification of your portfolio, your risk tolerance and more. Let’s break down the two strategies to show the advantages and disadvantages of each.
Lump-sum investing is exactly what it sounds like. An investor with a lump sum of investable assets, or cash in hand, injects the entire amount into a single trade, and the entire purchase of a stock is made at one price. For example, an investor with $1,000 could purchase 20 shares of a stock valued at $50 per share. When the price of the stock rises above $50, the investor sees gains in each share. When the price of the stock drops below $50, the investor sees losses in each share.
Dollar cost averaging, on the other hand, is a strategy used to minimize some of the losses in market investments. It is the process of systematically investing the same amount of money into a stock over a long period of time. If we take the same investor with $1,000, they might purchase $50 worth of stock each month. In the first month, the investor would get an entire share. As the price rises, that $50 purchases less than one share, but if the value of the stock drops, the investor gets more than one share, bringing down the average cost per share.
While lump-sum investing has the greatest potential for a boom, it also has the greatest potential to go bust, and that bust can be reflected both in your stock portfolio and your psyche. If our investor purchases 20 shares of a stock at $50 per share all at once, lump-sum investing could really pay off if the price of the stock rises to $100, effectively doubling the initial investment. Similarly, if the price of the stock is sliced in half to $25 per share, so is the initial $1,000 investment along with, presumably, the investor’s sanity and confidence.
A key component to lump-sum investing is timing the market, which is nearly impossible to do. Modern stock projections may be based on historical data, but there are no guarantees in the stock market, and there are no proven ways to determine when investments hit peaks or valleys.
The idea behind dollar cost averaging is to protect investors on multiple fronts. Let’s look at the same scenario as our lump-sum investing example. If our investor using dollar cost averaging purchases one share of a stock at $50 in the first month, then the price surges to $100 in the second month, dollar cost averaging may cost the investor. Instead of doubling the entire investment, the investor has made just $50. If the investor sticks to dollar cost averaging, they would then purchase another $50 worth of shares, which would be just half of a share. Now the investor has paid $100 for a share and a half, making the average price per share about $67 instead of the original $50.
On the other side of that scenario, if the price of the stock dips to $25 per share, not only does the investor lose just $25, but they are also presented with another exciting buying opportunity. Through dollar cost averaging, the investor would then purchase another $50 worth of stock, which in this case would amount to two shares. Now, having spent $100 on three shares of the stock, the investor is into the stock at just over $33 per share. For the investor to come out ahead, now the stock must only rise above $33 versus rising above $50.
Obviously in a perfect world, the investor purchases all of their shares at $25 per share, but again, timing the market is incredibly difficult. Dollar cost averaging allows an investor to take advantage of valleys, even after buying at peaks. In fact, lower price points allow for the purchase of more shares, giving more weight to the less expensive shares simply through increased volume, thus bringing down the average cost per share.
Historical trends show indexes rising since their inception, weathering bear markets and periods of decline, so dollar cost averaging has the potential to be a strong long-term pay for an investor with time and patience. In fact, it’s much of the reason that retirement accounts, like 401(k)s and IRAs, are valuable for those who contribute early and often.
At Sun Valley Financial, we believe that dollar cost averaging is the best way to approach the market and take advantage of fluctuations and volatility. When there is no concrete way to know when the market will bottom out, falling stock prices can become an opportunity instead of a death sentence.
Investing is a process that requires practice and patience. Reach out to Sun Valley Financial at 602.960.0362 for a no-obligation consultation to review your investment strategies. Money is merely a tool to be used to chase your dreams, and we can analyze your situation to find out if you’re chasing your dreams efficiently. As always, be sure to check with your financial professional before making decisions, and until next time, stay well!