The Smartest Investors Use This Strategy in a Market Rally
Imagine you’ve been holding cash while waiting for the market to turn so that you can ride the next bull market to colossal investment returns. Growth stocks have steadily gained steam over the past couple of weeks, and you’re ready to jump in for the ride.
That urge to pile into the market is called the fear of missing out, or FOMO. Don’t let this emotion set you up for a lesson in market volatility; instead, use the strategy described here, so that you’re investing with your brain and not your feelings.
The problem: You can’t predict volatility
Piling into a stock all at once is just guesswork. That two-week rally might be just another bounce before a stock heads lower, and stock prices can always head lower. Of course, the rally could also be real, but that’s the point. Nobody knows, and it’s often in hindsight that you think to yourself, “Ah, that was the turning point.”
People have tried timing the market’s moves forever, but most don’t appreciate just how tiny a needle they are threading. The S&P 500 has returned 17,715% from 1930 to 2020. But if you missed the best ten market days each decade, your total returns would be just 28%!
Nobody knows the future. The market is notoriously unpredictable in the short term, driven by emotions like fear and greed. You can’t know for sure what world events, political developments, or economic changes might occur that change the trajectory of Wall Street on a given day.
Sure, you’ll win big if you guess right, but the lottery works the same way; the vast majority lose.
The solution: Dollar-cost averaging
You can do very well in the market if you go for base hits instead of the home run every time you’re at the plate. A dollar-cost averaging strategy can help you do that. Dollar-cost averaging is when an investor slowly builds an investment with multiple smaller purchases over time.
This strategy has two primary benefits: First, multiple purchases assure you’re not taking one big swing and getting the timing wrong. You might feel confident buying a full position in stock X at $50 after it fell from $100, but it won’t feel good if it continues dropping to $25, and dollar-cost averaging fixes that.
Second, the math works in your favor. Making scheduled purchases in fixed amounts means your money is doing more work for you when shares fall lower. For example, you would buy twice as many shares by spending $1,000 on a stock at $25 than when it’s at $50. You spend the same amount of money but will benefit from lower share prices.
Over time, you’ll build a position in an investment that blends all of your purchases into an average cost basis. It won’t be the best or the worst, but you’ll put yourself in a position to succeed over time.
An example to demonstrate
Let’s close with an example. Imagine you want to invest $5,000 in stock X. It’s a growth stock that can be very volatile. You make five purchases of $1,000 each over the next year at the following prices:
- 20 shares at $50
- 25 shares at $40
- 50 shares at $20
- 100 shares at $10
- 40 shares at $25
Your total investment would include 235 shares at an average cost of $21.27. Everyone would love to buy their entire investment at $10 per share, but they’re more likely to pile in too soon, riding the stock into deep losses.
Meanwhile, your cost average means you’re already up on your investment as the stock begins recovering to $25. It’s a lot less stressful and can help you build a solid cost basis, especially if you’re a long-term investor with a multiyear time frame. That sounds like a win-win to me.
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