Cautious investors should consider a number of strategies that are formulated to enter and exit the market in a predetermined manner.
First, by buying shares on a periodic basis, it is possible to accumulate more low-priced shares. This dollar cost averaging requires constant purchasing with a fixed sum for a year or two to be effective.
Second, consider balancing your portfolio between stocks and other fixed-income securities. Whatever ratio you decide on, the success of the plan rests on your ability to monitor and act on imbalances.
Third, reinvest your dividends to purchase new shares. This is a painless way (if you do not need the dividend income) to increase your stake in the company. Remember that in the long run, a stock's value is a reflection of its dividend stream.
Earnings and projected future earnings are all important in the stock market. Get the consensus earnings estimate before you buy a company, and then monitor those earnings (and future earnings) to see that there are no surprises.
Averaging up
Paying attention to the business cycle is a classic approach to the key problem of timing purchases and sales. However, there are other equally successful ways to invest that rely on different techniques and philosophies. Some investors use one method, some another, but there is no reason not to mix them.
One truism that appears valid in the investment world is the simple observation that no one technique works all the time. Just as you diversify a portfolio with 8, 10 or 15 companies in order to eliminate company risk, it is wise to consider and implement different approaches.
One answer to the problem of timing is to pass: It is too difficult and too tenuous to place much faith in it in the view of some. Ignore timing and implement a strategy that does not rely on the vagaries of the business cycle and a host of sometimes confusing leading indicators. By using a fixed formula, the issue of when to buy and when to sell is not subject to a judgment call.
Dollar cost averaging is perhaps the most popular of these plans. By regularly purchasing the same dollar amount of securities over a long period, it is possible to buy more shares at low prices than at high prices. Thus the investor accumulates more low-priced shares than high priced shares. This is a systematic method of buying shares at an average cost that is lower than the average price of those shares.
For example, an investor decides to buy $ 1,000 of stock each quarter of the ABC Company. Its shares are $50 each at the start of his dollar cost averaging. His program might look like the one in Table 1.
Table 1: Dollar Cost Averaging for the ABC Company
Quarter | Price per share | No. of shares | Share cost |
1st | $50.00 | 20 | $1,000 |
2nd | $43.00 | 23 | $1,000 |
3rd | $55.00 | 18 | $1,000 |
4th | $66.66 | 15 | $1,000 |
5th | $70.00 | 14 | $1,000 |
6th | $80.00 | 12 | $1,000 |
7th | $85.00 | 12 | $1,000 |
8th | $90.00 | 11 | $1,000 |
Total | $539.66 | 125 | $8,000 |
Average Price | Average cost per share | ||
$539.66 � 8 = $67.46 | $8,000 � 125 = $64 | ||
At the end of two years, the investor spent $8,000 for 125 shares worth (@$90) $11,250. With $8,000 he or she could have bought 160 shares at $50 initially (if the money had been available), which would have been worth $14,400.
At the other extreme, an investor could have bought 89 shares for $8,000 at the end of the period, Clearly, low stock prices, are better than high stock prices since more shares will be accumulated. This form of investing also works best when there is predictable growth and a real likelihood of higher prices. It works best with volatile issues and it can be used easily with mutual funds in order to provide diversity.
This system ensures that the investor will not load up with high-priced issues. When prices decline, the damage to the portfolio will not be as great as it otherwise might have been.
There are some disadvantages as well: Commission charges for odd lots (less than a hundred shares) can be high; there is a natural reluctance to buy when prices are high; there is also a natural sense to sell out when prices are depressed rather than maintain the program; and dedication to constant buying of a company's shares may blind one to problems that develop within that firm over time.
Other formula plans
Other formulas are also useful to the passive investor. The constant ratio plan is a simple way to keep equilibrium between common stock and fixed-income investments.
You could start a program by dividing your portfolio (or intended portfolio) in half: 50 per cent of the value in common stock and 50 per cent in bonds. The holdings are evaluated on a regular basis, say, every three or six months.
If the stock side increases beyond a given point, say, 60 per cent, some stocks are sold. If it declines below 40 per cent, some stocks are bought. As prices rise, the profit from the sold stocks is converted into bonds. As stock prices fall, some bonds are sold to buy more shares.
This system keeps the investor balanced and allows for profitable, programmed trading. Obviously a judgment on asset allocation has to be made as to whether 50-50 is appropriate or 90-10 would better serve.
This judgment must also be made by employee-shareholders of company pension plans. Many company income-sharing plans require or request the participants to select how their retirement funds are to be balanced for the forthcoming year.
Another variation of a passive investment program is the constant dollar plan. An investor establishes a safety point in dollar terms above which he or she will not venture any further funds in common stock. Whether it be $20,000 or $100,000, the safety point is one that keeps his or her portfolio from experiencing too much exposure.
The portfolio sells shares if that point is crossed, reinvesting in the more conservative fixed-income side. On the other hand, the portfolio sells bonds and buys shares when the stock side is substantially below the safety point.
Dividend reinvestment plans
Dividend reinvestment plans, under which dividends are used to purchase additional shares of stock, are a convenient and inexpensive way to add to holdings. The vast majority of companies do not charge fees for joining the plans; some even offer a discount from the market price.
Dividends reinvested through these plans are taxable to the participant (unless they are in tax-deferred accounts), as is the difference between the fair market price and the discounted price. For more information about these plans, contact the company's shareholder relations department for a copy of the plan's prospectus.
Timing in these formula plans is predetermined by the market's actions. It removes the possibility of active intervention on a whim if the plan is rigorously followed. Critics object to the mechanical artificiality of these schemes.
They keep investors from fully participating in long and sustained trends in a business cycle. But then, investors wish to be protected from such participation by definition. They wish to make progress slowly and methodically: the tortoise, after all, did beat the hare.
[Excerpt from The Basics of Stocks by Gerald Krefetz.
Gerald Krefetz is a principal of Krefetz Management and Research, he runs a private money management service for individuals in Manhattan, USA and has written more than twelve books.]
