An investment strategy that aims to buy stocks slowly is likely to have become less popular in recent months. The stock market's surge to an all-time high means many investors may feel that investing in stocks as soon as capital becomes available is likely to be a more profitable method. After all, a rising equity market can cause investors to fear missing out on potential future gains.
However, a dollar cost averaging strategy could be particularly effective in a bull market. This strategy constitutes buying a single stock in multiple transactions over a period of time, as opposed to a lump-sum investment. The potential for market fluctuations could mean this represents a relatively efficient use of capital.
The benefits of dollar cost averaging
A key benefit of dollar cost averaging is the potential to average down on a stock at a lower price in the future. This reduces an investor's average cost per share. The chances of this happening at the moment may seem slim due to the stock market's ongoing rise. However, rich valuations among many companies, political changes and economic uncertainty may mean that the stock market's future progress is interrupted.
Bear markets have always occurred following bull markets. On average, stocks have lost 36% of their value in previous bear markets. This could provide investors with the opportunity to buy stocks at significantly lower prices than today via a dollar cost averaging strategy.
In addition, buying stocks slowly can provide greater peace of mind in a market downturn. An investor who still has capital to invest may find it easier to cope with a sudden and sharp decline in stock prices. This may help them to focus on company fundamentals so they can make rational decisions, rather than becoming swept up by emotions in a rapidly-falling stock market.
Using a dollar cost averaging strategy
Baupost cofounder Seth Klarman (Trades, Portfolio) has been an advocate of a dollar cost averaging strategy for many years. As he once said:
"In my view, investors should usually refrain from purchasing a 'full position' (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to 'average down', lowering their average cost per share, if prices decline".
Of course, buying a stock in multiple transactions can lead to higher costs versus a single purchase. For instance, multiple commission payments will be required. There may also be an opportunity cost in terms of missing out on capital growth if a company's share price increases. This cost could be particularly high at the moment, since the returns on other assets such as cash are extremely low.
Investing slowly in today's stock market
In my opinion, dollar cost averaging is a useful investment strategy in the current bull market. Many stocks trade on rich valuations based on optimistic forecasts that may not factor in economic and political uncertainties. This could mean their future growth is more limited than their recent gains as a result of them having little or no margins of safety.
Determining when a bear market will occur may be impossible due to the infinite number of factors that can affect stock prices. Therefore, investing slowly in anticipation of the recent bull run coming to an end seems to be a prudent means of capitalizing on today's undervalued stocks.
Read more here:
- Warren Buffett on the Importance of Holding Cash
- Peter Lynch on Obtaining Growth at a Reasonable Price
- Howard Marks: Don't Forget About the Market Cycle
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