The first rule of investing is to protect your capital.
Let's say you make a lump sum investment of $10,000 in a mutual fund, or several stocks. Of course you hope the investment will go up in value. But if you are wrong and it drops, say, 30 per cent over the next year, you will end up with $7,000.
On the other hand, if instead you had invested $1,000 a month for 10 months, not only would you have reduced your loss but you would have been buying additional mutual fund units or stocks at ever-lower prices. So when the market did start to rise again, you would have more mutual funds or stocks in your portfolio.
Yes, if the market did indeed go up during that year, you would have made less money with this dollar- cost-averaging approach than with the lump sum investment.
But going back to the capital protection first rule of investing, most people are better off to miss a chance of making money than to take a chance of losing money.
In the stock market, you can extend this approach by choosing companies which offer a dividend reinvestment plan. A DRIP uses your dividends to automatically buy more shares of the company.
The Investment Reporter newsletter cites a dozen DRIP benefits - from forced saving and compounding to in some cases lower transaction costs and share prices - and regularly publishes a list of Canadian and U.S. companies that offer these plans.
Commenting on the dollar-cost average approach, the newsletter says: "Stock markets suffer from bipolar or manic-depressive disorder - and there is no cure. "Buying more shares when prices are low and fewer shares when prices are high gives you a below-average adjusted cost base."
And while you wait to invest your money, holding cash isn't necessarily a bad thing - even though these days you are earning little or no interest: (1) You can take advantage of investment opportunities. (2) If you suddenly need money, you don't have to liquidate investments when values are down.
Mike Grenby is a columnist and independent personal financial advisor; he'll answer questions in this column as space allows but cannot reply personally. Email [email protected].
