“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.”
Investing seems easy and fun during a bull market. To uneducated investors it can seem as though the good times will never end. There’s an old wall street saying that “everyone’s a genius during a bull market”. When volatility returns however, the fun vanishes. Uncertainty swiftly takes its place. After continued drops in the market, people lose interest in the stock market altogether.
However, history tells us that these “bear markets” are the best times for long-term investors to buy. Regrettably, most of us miss these opportunities because our emotions get in the way. After markets fall for a prolonged period, we naturally get gun shy and feel that it’s too risky to put in any new money. In reality, that’s usually the least risky time to buy. Why? Because most people have already sold. So there are potential buyers out there to eventually drive prices back up.
On the flip side, when the markets have been going up for years, things appear safest. All of our friends are in the market, and we feel as though we’re in good company. The herd is there with us! When in reality, things are risky for that very reason—nearly everyone who wanted to buy is already in.
While the idea that emotions can drive entire markets may seem far-fetched, it’s actually the subject of an entire field of study—behavioral finance. And as far as emotions influencing our day to day investing decisions, that’s also backed up by research. Dalbar, a financial market research firm, found that the average investor underperforms the indexes, even when using ETFs and index funds! Why would this be the case? Per Forbes magazine, “Investors may only have themselves to blame. According to Dalbar’s QAIB, ‘investors make poor investment choices that hurt their investment returns. These decisions, including when to buy and sell, are often driven by emotion.” Sometimes we panic and sell, then only later feel it’s safe to buy back in. Guess when that is? Right—when the market has already recovered and again “seems safe”.
This is why it’s so hard to “buy low” and “sell high”. Our emotions naturally drive us to do the exact opposite.
When the market has been going up for an extended period of time, we naturally want to buy more, this time at higher prices. But when things are on sale after a price drop, it seems risky, so we naturally want to buy less.
Strange isn’t it…for a species that voluntarily lines up for Black Friday sales, we naturally want nothing to do with stocks on sale, and we actually prefer to pay more.
This just highlights how irrational our emotions can cause us to act. However, with proper education we can recognize these natural destructive tendencies and act in spite of them, but it takes awareness and discipline.
What if there was a simple way to avoid our emotions altogether when buying stocks (or mutual funds or ETFs)?
There is…it’s called Dollar-Cost Averaging.
How does dollar cost averaging work? It’s very simple. You just decide to invest a specific (fixed) dollar amount at a specific time interval in the same investment. For example, you might decide to invest $500 on the 1st of every month in an S&P 500 index fund.
The key is that you cannot vary from the formula. Always invest exactly $500 on the exact same day of the month, and buy the same investment. The only thing that will vary is the amount of shares you receive each time.
When prices are low, you will automatically buy more. When prices are high you will buy less. You no longer have to worry about judging just how high or low the prices are, or worrying if you should or should not be buying now. In fact, you don’t have to worry at all.
What’s happening here? The system creates discipline for us. You don’t have to work at it, or worry about it.
While it’s not perfect, dollar-cost averaging removes the most dangerous component of our investing: our emotions.
Investing is never easy and that’s why research shows those with professional assistance get better returns. An advisor can help you with the more complex tasks of financial planning, asset allocation, rebalancing and helping you reach your short-term and long-term goals. And most importantly help you avoid the destructive emotional mistakes that investors are naturally prone to making. But with dollar-cost averaging, we’ve got an easy system to keep us putting new money into the market consistently. The longer you use this system, the better the results. For long term investors who don’t need this money for a couple decades or more, history shows us that periodic bear markets won’t matter. While no one has a crystal ball, the market has always recovered and has continued to beat inflation by a wide margin over the long term.
What dollar-cost averaging cannot do well is help us invest a lump sum. Research shows it can work against us in that scenario, lowering our returns. So if you have a chunk to invest, work with your advisor to make sure it’s invested in an appropriate way that fits your unique situation and goals.
But for long-term investors, dollar-cost averaging is an ideal way to keep your sanity intact during volatile times. By using this system, we give ourselves a shortcut to that discipline that Warren Buffett possesses. The best part? By taking emotion out of the equation, you can trust the system will help you avoid some of those expensive mistakes. So, you can relax and maybe even look forward to the next bear market, whether it starts tomorrow or a few years down the road.
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