A “Must Know” Strategy For Investing In Volatile Markets

For the past few weeks, there has been a lot of discussion about the stock market’s direction and what could be the extent of this correction we’re apparently in the middle of.

The correction has been officially identified by many market professionals. Last week I too discussed it, in light of the market’s (rich) valuation and historical perspective. I then mentioned in my “What to do?” concluding thoughts the concept of “taking advantage of lower prices to pick up solid long-term holdings…”

Well, that phrase could use further elaboration. I gave you some broad words of solid wisdom, and today I will try to explain in more detail.

There is a well-known tactic that long-term investors use for building their positions over time. I’m sure some of you are at least familiar with what is known as “Dollar Cost Averaging” or “DCA.” (I really hope most of you are already incorporating dollar cost averaging into your stock purchasing methodology.) In fact, through direct investment plans, IRAs and 401(k) type programs, you may be doing DCA and might not know it. And with less visibility and the markets going up and down so much, DCA makes more sense now for most investing efforts.

Let’s look a little closer at some Safe Haven Investor examples to better convey the importance of (and strategy behind) dollar cost averaging.

DCA Defined

Dollar Cost Averaging is a sound buying (and selling) strategy that works well when stocks prices are moving up and down.

Let’s say you were a long-term reader of Safe Haven Investor and back in November of 2008, you took our advice and added HudBay Minerals (HBM:TSX) to your portfolio.

HudBay Minerals is a Canadian integrated mining company that has been a great addition to the Safe Haven portfolio, up 113% since we recommended it on Nov. 7, 2008. But I don’t want to talk about that awesome return - I want to talk about DCA.

On that date the HBM price was $6 a share. You could have made a lump-sum or “one time” purchase, say of $3,000 worth, for 500 shares.

That’s great, but sometimes you gradually want to add to your position. Perhaps you don’t have all the money at once, or you want to do it monthly or quarterly. Deducting a set dollar amount out of your monthly paycheck to purchase shares is a common example. That, simply, is dollar cost averaging.

With dollar cost averaging, you add to (or reduce, if the case may be) a position periodically, effectively “averaging” your total dollar cost. This works great if you’re buying a stock and the price tends to be lower than your “one time” price.

This is kind of important. If you have a comfortable and ongoing strategy of dollar cost averaging, than you pay less attention to dips in the stocks you are buying. As long as you are still comfortable with the investment rationale behind buying the stock, and nothing material has changed with the company and its fundamentals, then dollar cost averaging will let you buy with confidence. As Peter Lynch suggests, “The key to making money in stocks is not to get scared out of them.”

On the other hand, if the stock starts rising, then your average cost could be higher. But in this environment, if that happened to be the case, I might not mind paying a higher price when there is a near-term risk of the stock dropping down lower. If the stock does go higher, you are buying fewer shares at that higher price with the same dollar amount.

Also, if there is a chance your investment (temporarily) turns sour, at least you will be entering at a lower and lower base, allowing the opportunity for positive returns sooner.

The HudBay Example

Back to HudBay for a moment. In the chart below, using $3,000, we compare a lump-sum purchase at $6/share vs. dollar cost averaging for six months since the Nov. 7 recommendation.

With Dollar Cost Averaging, our “average” price would have been $5.17, allowing us to own 528.6 shares, compared to a lump-sum purchase on Nov. 7, 2008, where the “average” price was $6, giving us 500 shares.

Having an average price of $5.17 vs. $6 is a major difference! Actually, by dollar cost averaging, you would have been up 16% already, which over the long run and with larger dollar amounts would have a meaningful impact on your portfolio. And in HudBay’s case, this is before the stock doubled and made its run to the low teens.

So, now you know about Dollar Cost Averaging - which in this market could serve you well.