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  4. Check website http://www.emigrantdirect.com  for more ideas

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Asset Allocation

Dollar Cost Averaging

Asset Allocation

Astute investors never put all their funds in one stock, or even in one mutual fund. It is important that the various mutual funds in a portfolio are of different asset classes and all have different investment objectives. Thus, varying economic cycles, the losses suffered by those assets declining in value are offset by gains in those assets increasing in value. Furthermore, since investment returns from varying classes of assets tend to move in opposite directions at times, individuals who invest "across the board" obtain additional risk reduction due to the low correlation of investment returns among the classes of assets.

The biggest investment decision made by an investor is not which stock or bond to own, but the proportion of stocks, bonds, cash and tangibles (gold, real estate, etc.) to won at any time.

Gold, precious metals and real estate perform best in an inflationary environment, while bonds perform poorly. During periods of deflation, gold and real estate investors suffer while bondholders reap abnormally high real returns. Falling higher stock prices. A falling dollar coupled with a large trade deficit, favors international investments over domestic investments. While investors should position their overall portfolios to take advantage of the best performing assets, optimal asset allocation requires that investors anticipate changes in economic trends and take appropriate action before such trends are well underway. This type of asset allocation requires constant changes in the distribution of assets in a portfolio. Although fixed asset allocation will also achieve a similar goal of diversification for the long-term investor, it will not earn the high returns of active asset allocation. However, fixed asset allocation carries less risk than active asset allocation.

Once an investor establishes a portfolio, he then needs only to monitor the funds in each asset class and select those, which promise the best future investment return regardless of economic scenario.

Dollar Cost Averaging

Dollar cost averaging is the purchase of equal dollar amounts of an investment at regular time intervals. Following this strategy, a fixed dollar amount is invested in a security in each period. The investor must make a commitment to invest on a regular basis in order to make the plan work. The desired outcome of a dollar cost averaging program is growth in the value of the security to which the funds are allocated. The price of the investment security to which the funds are allocated. The price of the investment security will probably fluctuate over time. If the price declines, more shares are purchased per investment period. Conversely, if the price rises, fewer shares are purchased per period.

For example, suppose an investor decided to invest $1,000 in a mutual fund each month. The first month, a share of this mutual fund is $20, so $1,000 purchases 50 shares. The next month, the price of a share of this fund has doubled to $40, so the same $1,000 purchases only 25 shares. The third month, the share price plunges to $10, allowing the purchase of 100 shares. The fourth month, the price recovers again to $20 and additional 50 shares are purchased for $1,000.

Over this four-month period, the investor purchased 225 shares for $4,000. However, the price at the end of four months is $20 per share, so the 225 shares are worth $4,500. Thus, a gain of $500 was made on a $4,000 investment; this is a return of 12.5%. Of real significance, though, is that \this was accomplished even though $3,000 was invested when the price of the shares was at or above $20, the current price.

Over the long term, dollar cost averaging almost always achieves this remarkable result. The average cost of mutual fund shares purchased this way w3ill always be less than their average value. The reason that dollar cost averaging works is because investors who are disciplined enough to follow this plan are forced to invest funds even when the market drops. Investors who follow their emotions would probably stay out of the market when it was down, and thereby would fail to make a profit. With dollar cost averaging, the average cost per share is lower when the investor buys at market bottoms as well as at market tops, instead of trying to guess where the market is going next. And the more frequently a fixed amount of funds is invested under a dollar cost averaging plan, the better the plan will work. A weekly or monthly investment is best.

To show just how reliable dollar cost averaging is, Dr. Rober H. Persons, author of The Handbook of Formula Plans in the Stock Market, evaluated a dollar cost averaging program that started right at the top of the stock market in 1929 and rode out the whole Depression. He made a hypothetical investment every year in the 30 stocks that make up the Dow Jones Industrial Average. Persons also loaded the dice against dollar cost averaging y putting in his fixed investment at the market top for each year.

Naturally, the portfolio lost money in the crash of 1929, but by 1935 the portfolio was already in the black (see Table 1). The reason is that the discipline of dollar cost averaging forced him to buy large numbers of shares in 1933 in the depths of the Depression.

Table 1

Dollar Cost Averaging: 1929 - 1932

Amount

Invested

Year

Annual Return

Total Losses

Year end Portfolio Value

$10,000

1929

+8.4%

-$840

$9,160

$10,000

1930

-24.9%

-$5,611

$14,389

$10,000

1931

-43.3%

-$16,273

$13,728

$10,000

1932

-8.2%

-$18,228

$21,772

0

1933

+54%

-$6,471

$33,529

0

1934

-1.4%

-$6,940

$33,060

0

1935

+47.7%

gain

$48,830

It took the Dow Jones Industrial Average until 1954 to recover its peak of 1929, but by that time the hypothetical dollar cost averaging portfolio had doubled the investor's money. And by 1966, when Persons ended his study, the Dow was up 161% over its 1929 high, but the dollar costs averaging portfolio had appreciated 336% over cost.

 
 
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