Last week I wrote about an investing strategy called dollar-cost-averaging – the act of systematically buying more shares of your favorite stock or mutual fund in regular amounts every week or month. Generally, dollar-cost-averaging works best when markets are volatile and trending downward or sideways. With each new investment you end up buying more shares at lower prices, lowering your average cost per share over time.
Buy low. Sell high. That’s the age old maxim for investing success. Dollar-cost-averaging in a downward or sideways stock market allows you to buy more shares at lower prices.
But what if markets are at a peak? Is there a way to systematically sell high when markets are at their loftiest levels? If dollar-cost-averaging works when markets decline, perhaps a reverse strategy – one in which you sell a certain number of shares on a systematic basis each month – would work when markets are at all time highs, as they are now.
Here is the logic: On July 10, 2017 the S&P 500 closed at 2,441, just 12 points below its all time high. Today some investors worry that the next bear market (by definition, a market decline of 20% or more) may be just around the corner.
During a typical bear market stock prices decline about 35% and take roughly a year or more before they reach a bottom and begin to improve. Of course, it could be much worse than that. In the bear market of October 2007 – March 2009 the S&P 500 lost over 50% of its value in less than 18 months.
Obviously, if you wanted to “sell high” you would have been wise to sell some of your stock and mutual fund shares prior to October 2007. Likewise, if you had a long time horizon could afford to ride out the bear market, you would have come out OK as well.
I am not a fan of trying to time the stock market, but I am a fan of being careful when it comes to investing. That means focusing on the long term and perhaps not having 100% of your money in the stock market. If you will need to cash in some of your investments over the next few years to pay for college or help fund your retirement, it may be smart to sell some shares while share prices are still high.
Reverse Dollar Cost Averaging. If markets continue to rise, it may make sense to sell a fixed dollar amount or percentage of your stock funds while stock prices are still high. Doing so allows you to take a profit on appreciated assets, and builds up your cash position reducing your exposure to market risk while also providing additional cash to reinvest after markets have experienced a significant drop.
If dollar-cost-averaging works in a declining market, the opposite, reverse dollar-cost-averaging, works best in a rising market. The idea is to reduce market risk before stocks take a steep slide in the wrong direction.
Warning: this strategy has its flaws. Both types of dollar-cost-averaging are types of market timing and timing the markets is notoriously difficult. With reverse dollar-cost-averaging the risk for long-term investors is that markets continue to rise for a long time and you will miss out on investment gains that you would have received had you stayed fully invested in the market.
Right now we are eight years into the current bull market cycle – the second longest in history. However, the longest bull market since WWII was from 1987 to 2000 – a period of 13 years. A reverse dollar-cost-averaging strategy during an extended bull market delivers lower total returns on your investments since a larger percentage will be allocated to cash or other short-term, low risk investment options that are unlikely to appreciate significantly.
Reverse dollar-cost-averaging can also be painful for retirees living on investment income. If your favorite company stock is trading at $100 and paying you a $3 dividend, selling that stock eliminates the dividend. Now you have to find some other way to generate $3 on a $100 investment – a tall order in today’s low interest rate world.
The best strategy of all. Perhaps the best strategy of all is also the simplest: decide how much market risk you can reasonably tolerate, tie your investment decisions into your long-term financial goals, allocate your portfolio accordingly, and stick it out for the long-term.
Strategies like dollar-cost-averaging and reverse dollar-cost-averaging may be effective and appropriate in the right situations, but the best strategy when markets reach new highs may be to just be careful. Being careful may produce a lower total return when markets rally strongly like they’ve done over the last several years, but it also helps preserve principal, reduces market risk, and helps you sleep at night when the tide eventually turns.
I like being careful.