Market Ups And Downs Are Good For You
Many people, if given the choice, would prefer if their investments always went up in a straight line. This seems intuitive. The ups and downs in the market are what experts consider risk. If would had the choice, why wouldn't we choose the scenario that had no risk?
Dollar-Cost Averaging
Dollar-cost averaging, or DCA, is a process whereby you invest the same dollar amount every period. For example, you might invest $100 every month or $1,000 every quarter. This has a couple benefits. Since you are investing the same dollar amount each period, you aren't paying any attention to the price. When the prices are up, you will buy fewer shares and when the markets have dropped recently, you will be able to purchase more shares. This is powerful because you get to consistently buy low (and hopefully sell high in the future).
For example, if I was saving $100 per month and investing that money in a total stock market fund and at the end of the first month the price was $27 per share, I would buy 3.7 shares. If at the end of the second month the price was $29 per share, I would be able to buy 3.4 shares. As the prices goes up I buy fewer and fewer shares. Let's say the market crashes and the prices of this fund fell to $17 per share. I would then be able to buy 5.9 shares at that lower price.
Rebalancing Similarities
DCA is very similar to rebalancing because in both cases we buy more of the investments that haven't performed relatively well. With rebalancing, instead of buying the same investment, you sell the investments that have done well and use that money to buy investments that have not done as well. So again, here is a way to consistently buy low and sell high.
For example, if you are investing in both U.S. stocks and foreign stocks and a year later the foreign stocks have done well and the U.S. stocks didn't do as well, you would sell some foreign stocks and buy more U.S. stocks.
Notice, in both DCA and rebalancing, we don't forecast the market to determine how much of an investment to buy or which investment to buy. We simply take what the markets have given us.
DCA and Rebalancing...Together
Using DCA and rebalancing together can be a great tool. If you have an established asset allocation policy - by that I mean you know which investments fit into your plan and what percentage of your whole portfolio goes into each investment - then instead of rebalancing by selling the winners to buy the losers, you would just put your new money into the investment that has performed the worst, relative to the other investments. Using these two together allows you to purchase investment that are on sale, over and over again.
Risk and Reward Are Related
So let's get back to the original question. Why would you choose a world with risk over a riskless world if you were given the choice? The answer if you are saving and investing your money regularly is that you want the markets to go on sale occasionally. This allows you to buy more shares than you would otherwise be able to purchase. It allows you to have more shares working for you when the markets recover.
In addition, risk and reward are related. The financial markets reward us for taking financial risks. If there was a world without risk, we shouldn't expect much reward for that. If we can prepare ourselves to handle market downswings, the swings in the market become less scary and we can use those swings to our advantage.
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References:
William Bernstein: The Intelligent Asset Allocator
Charles Ellis: Winning the Loser's Game
Rick Ferri: All About Asset Allocation
Roger Gibson: Asset Allocation
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