When markets move, that can feel like a terrible time to buy. We love the idea of “buying the bottom” but hate falling prices. And it always seems that the best investments are the ones everyone else is buying — everyone but us.
To remedy this, financial advisers tell people to use dollar-cost averaging (DCA). That’s the strategy of buying in equal lots throughout the year. In practice, using this approach means you get more shares or units of a given investment when prices are low and fewer when prices are high.
Sure, fewer shares is fewer, but you greatly reduce the risk of buying the absolute top. The price will swing up and down and you’ll buy almost all of the price points out there, over time. Getting the average is preferable to getting the high price when it comes to your long-term return.
Unless you have managed to find an investment that goes up and only up, DCA is a good tool to consider in volatile markets. But another way to do this is by rebalancing with discipline.
Think of rebalancing as DCA on steroids. Consider this simplified illustration:
Step 1. Buy a portfolio of index-tracking exchange-traded funds (ETFs) that includes stocks, bonds, real estate and commodities. This should be balanced according to appetite for risk and how many years of retirement saving you have ahead. Imagine it’s mostly stocks (60%) and then 30% bonds. The remaining 10% is split between real estate and commodities.
Step 2. Let’s say the stock investment portion rises in value, so much so that instead of being 60% of your holdings, the dollar value is now 65%. You don’t have any extra shares, but the value is higher.
Step 3. You sell that extra 5% to raise cash and reinvest it in the rest of your portfolio. You’re back to 60/30/10.
Step 4. In the meantime, some of your bonds and dividend stocks have paid income to you. You also have a fixed amount of cash saved from your current income that you would like to contribute. Take that cash and divide it evenly across the portfolio in the proportions you had originally set (60% stocks, 30% bonds, 5% each of real estate and commodities).
Step 5. Now the market declines (volatility!). Your stocks are worth less than 60% of the pie and, comparatively, your bond position (and perhaps the others) are worth more than your targeted level. You sell some of the bonds, real estate and commodities shares and buy stocks while they are cheap.
The strategy works for the same reason DCA works. It ensures that you own a balanced mix of investments at reasonable prices, but also that you sell them at relatively higher prices and buy them at relatively lower prices.
A rebalancing also strategy ensures that you are invested, even when the market seems unfriendly. That in itself — sticking to investing and staying on plan — is a major indicator of long-term investing success.