For most investors, the key to success is simple: Buy low and sell high. But a scenario like the following could play out:
- 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 instinctively right at the time, buying high and selling low may not result in a profit.
Why do investors do this? The reason may have a lot to do with us making investment choices the same way we make many important decisions: using both our heads and our hearts (in other words, both logic and emotion). When there’s market volatility — including both market highs and market lows — emotions may take over and we may make illogical choices that go against our best interests.
Rather than falling victim to the potential perils of emotional investing, you may want to be completely logical: Get into the market when it’s down and out when it’s up. This is known as market timing. While this approach sounds rational, the problem is that it’s extremely difficult, even for experienced investors, to do 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, that means anyone attempting to time the market finds it difficult to know exactly when to make a move.
For example, if you think the market has reached a peak and get out and then share prices keep rising, you’ll miss out on the additional profits you could have made by waiting. And after you get out, how do you know when to get back in? If you act too quickly, you’ll forgo better bargains as prices continue to fall. If you wait too long, you may sacrifice the chance to fully benefit from a market rally.
Give dollar cost averaging a look
In an effort to help avoid the potential problems of emotional investing and market timing, 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 (such as weekly, monthly, or quarterly) 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 at lower prices
- Fewer shares when prices increase
As shown in the table below, if the price is $24 per share, you’d buy 20.83 shares. If the price rises to $30, you would buy only 16.67 shares.
| Dollar cost averaging | ||
|---|---|---|
| Investing $500 per month over one year | ||
| Month | Number of shares purchased | Price per share |
| 1st Month | 20.83 | $24 |
| 2nd Month | 20.00 | $25 |
| 3rd Month | 17.86 | $28 |
| 4th Month | 16.67 | $30 |
| 5th Month | 18.52 | $27 |
| 6th Month | 22.73 | $22 |
| 7th Month | 20.83 | $24 |
| 8th Month | 18.52 | $27 |
| 9th Month | 19.23 | $26 |
| 10th Month | 17.24 | $29 |
| 11th Month | 17.86 | $28 |
| 12th Month | 18.52 | $27 |