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Dollar-Cost Averaging and Chasing Returns


The stock market ebbs and flows day-to-day and month to month. Generally, people don't like it too much when the market goes down. But, it is important that stock prices fluctuate downward as well as upward or most people could not afford to buy. Most people are familiar with the old investing mantra "buy low and sell high." Well, you could do neither if stock prices never went down.

You can use the ebbing and flowing nature of financial markets to your advantage by making regular investment contributions. Investing a small amount of money in the stock market (for example) on a regular basis enables you to buy more when stock prices are down and less when they are high. This is called dollar-cost averaging. Some people try to "time the market" by waiting until they think the market is at its lowest before they invest. Timing the market is the opposite of dollar-cost averaging and does not work for the majority of people who try it. Even trained professionals who study the market all the time are not typically able to beat it. The vagaries of the market make it difficult to predict with precision when key events will occur. To make market timing work effectively requires the utmost precision, however. There is too much randomness in the market for it to be predicted with the necessary precision. Luckily, most investors use dollar-cost averaging-and don't even know it-when they make regular contributions to their retirement plans at work.

Chasing Returns Is Bad Investment Practice

Whether investing or gambling, people tend to make the same sort of errors when trying to predict what events will occur in the future. One of the biggest errors they make is to think that distinct events are connected to each other; that because something happened or didn't happen in the past, that means that something will happen in the future. Slot machine players do this when they put coin after coin into their machines, thinking that since the machines did not pay off previously that it is becoming more and more likely that they will pay off in the future. There may be a grain of truth to this idea, but the chances of winning remain so small as to not be worth the price of admission. Gamblers are paying for entertainment, and not realistic chances at winning big money.

People make the same sorts of errors when it comes to investing. They see that a particular stock or mutual fund had very good returns last year. So, they decide that they will invest in that stock or mutual fund this year. Unfortunately, this sort of reasoning does not work well with gambling, and it doesn't work well with investments either. No stock or mutual fund has ever exactly repeated its returns two years in a row. Investing in a mutual fund merely because it had unusually high returns last year is called chasing returns (as in a dog that chases its tail but never quite catches it). If you invest this way, you will always miss the boat. You have to look at long term values when you invest for retirement. The fund that provided excellent returns last year could decimate your portfolio in the coming year if you invest too much of your money in it and it has a bad year. Your retirement money might be invested in particular investment vehicles for 25 to 30 years, so you should do your best to select vehicles that have a long-term, track record of good returns.

There are other reasons for trying to select stable, good performing investments and keeping your money in them over the long term. You pay fees whenever you buy or sell investments. The fees generated by frequent investment trading erode your returns. Swinging large amounts of money from one investment to another also inhibits your ability to benefit from the dollar-cost averaging discussed in the previous section.