In a climate where our economic recovery remains sluggish, it is amazing the heights that the Dow Jones Industrial Average has reached. Even though a historically large segment of American workers have gone without a job for a long period of time, investors currently enjoy a bull market with rates of return rising over the last year. This healthy stock market is occurring despite a shrinking middle class that persists due to job polarization eliminating many high-paying, moderate skill jobs. Despite this disturbing trend, corporate cash flows are replenishing at faster rates as investors flock to equities. Whether you believe this trend is sustainable or not, there is one strategy that can work in either case.
Consider dollar cost averaging as part of your primary investing strategy. Dollar cost averaging is investing the same amount of money each month, regardless of market conditions. When your investments are rising, it is true that each successive month of investing will buy less shares. For example, investing $100 a month when shares are $20 a share means that you can purchase five shares. If the stock price rises to $25 a month, that same $100 will only net you four shares. However, the upside is that you do not miss out on rising stock values by having your money sit on the sidelines.
On the other hand, a declining stock market means the value of your portfolio is declining. However, the advantage is that now your successive months of equal investing will purchase a greater number of shares. That means a $100 a month when shares are $20 each will yield five shares. However if the stock price plummets to $10 a share, an investor is now able to buy double their shares to ten. Since markets historically rise and fall, the value of your increased shares will eventually rise and result in even greater wealth in the long run.
It should be noted that the composition of your investments should vary based on age and risk tolerance. If you are young and do not expect to touch your investment portfolio for another 20 years or more, then I would recommend a more aggressive strategy of buying more stocks and less bonds. While bonds are usually very safe investments, they earn very low yields. Conversely, stocks are riskier and can lose substantial value, but they will earn substantially higher returns than bonds.
If you are near retirement, then your investment portfolio should include more bonds and less stocks. As you near retirement, your high earning capacity is limited. Therefore, it would be more difficult to replace lost wealth from a severe market correction. That is in contrast to the young worker, who has not reached their peak earning potential, meaning they have more time to recover from their losses.
Lastly, an unseasoned investor should consider index funds, which is a mutual fund where shares are bought and sold based on the movements of a particular stock or bond index. Index funds vary in risk, so one can customize their choice of index funds based on expected return and risk. The advantage of this strategy is that management fees are much lower and evidence shows that these index funds perform just as well, if not better, than those more costly managed funds where highly paid fund managers try to predict trends in order to earn higher rates of return for their clients.
It is foolhardy to predict the direction of the market, so adopt dollar cost averaging and rest easier each night.