Does this scenario sound familiar?
When the market is up, an investor feels good and buys stocks. When the market is down, that same investor gets scared and sells.
Although reacting like this may feel right at the time, the problem is this scenario is unlikely to result in a profit. In fact, the goal should be just the opposite: buy low and sell high.
Why do investors make this mistake? The reason may have a lot to do with us making investment choices the same way we do many important decisions – using both our heads and our hearts (i.e., logic and emotion). When there’s market volatility – including both market highs and market lows – our emotions tend to take over and we might make illogical choices that go against our best interests.
To avoid having your emotions control your investment decisions, you might decide to get into the market when it’s down and get out of the market when prices are up. This is known as “market timing.”
While this approach might sound rational, the problem is this strategy is extremely difficult, even for experienced investors, to employ consistently. There’s an old saying: “No one rings a bell” when the market reaches the top of a peak or the bottom of a trough. Translated: Investors attempting to time the market usually find it tough to determine exactly when to make their move.
Give dollar cost averaging a look. Rather than using either of these approaches, consider a strategy called “dollar cost averaging.”
Dollar cost averaging is the practice of putting a set amount into a particular investment on a regular basis (weekly, monthly, quarterly, etc.) no matter what’s going on in the market. For example, you could invest $500 each month. In a fluctuating market, this practice lets you purchase additional shares when prices are low and fewer shares when prices increase.
While you’re mulling dollar cost averaging’s potential merits, consider this: You may well be using the strategy already. If you participate in an employer-sponsored retirement plan, such as a 401(k) or 403(b), and contribute the same amount each payday, you’re using dollar cost averaging.
Get help for when the going gets tough. One of dollar cost averaging’s greatest challenges is you have to stick with the strategy even when the market declines, and that can be difficult. (See our previous discussion about letting emotions control your decision-making). However, during times like these, dollar cost averaging can be most useful by letting you purchase shares at lower prices.
Because dollar cost averaging can be simultaneously more difficult and advantageous when the going gets toughest, consider turning to a professional financial advisor for help. He or she should offer a voice of reason during these periods as you grapple with whether to adhere to the strategy.
Like any investment strategy, dollar cost averaging doesn’t guarantee a profit or protect against loss in a declining market. Because dollar cost averaging requires continuous investment regardless of fluctuating prices, you should consider your financial and emotional ability to continue the program through both rising and declining markets.
This article was written by/for Wells Fargo Advisors and provided courtesy of Whitney McDaniel, Financial Advisor in Beaufort, SC at [843] 524-1114. Any third-party posts, reviews or comments associated with this listing are not endorsed by Wells Fargo Advisors and do not necessarily represent the views of Whitney McDaniel or Wells Fargo Advisors and have not been reviewed by the Firm for completeness or accuracy.
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