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Over the years, there have been several methods developed to help investors determine when to purchase stocks. Despite the proliferation of computer programs one can install on their computer, these methods are still valid. These plans were developed to help investors gain some protection and cushion the blow should they purchase the stock at an unfavorable price. This section will cover the three plans that are not technical in nature. These are 'Dollar Cost Averaging', 'Constant Dollar', and 'Constant Ratio'. Systems based on moving averages, trends, price earnings, book value, etc., are not covered here. By the way, the three systems presented here are also valid with respect to mutual fund purchases. Keep in mind these systems do not assure a profit, nor do they protect against loss in a declining market. Since such plans involve continuous investment in securities regardless of fluctuation in price, the investor should continually evaluate his or her financial ability to continue the program, especially in light of certain ‘life changes’: retirement, family status change, etc. |
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Dollar
Cost Averaging
This is probably the simplest plan among the three. This system consists of investing a constant dollar amount in common stocks over a long period of time at fixed intervals. The fixed intervals refers to weekly, monthly, annually, or some other time period, as long as it remains the same. For example, a person might invest $500 per month in common stocks. Or this same person might invest $3,000 every six months. The idea is to invest smaller amounts of money on a regular basis. It is a long-term system. The theory is that stocks can always be sold on the average for more than they cost. It does not get you in and out of trades. It only gets you in trades. The person must have a steady amount of income coming in and be willing to invest over a long period of time. This system shouldn't be used on just one stock. The investor may want to choose five or six different stocks to invest in this way. One or two different stocks could go down constantly. However, a properly diversified portfolio will go up eventually. This system doesn't mean that you should keep under-performing stocks in your portfolio. By all means, get rid of the dogs. There is a school of thought that says an investor should not purchase stocks with this program when they reach very high (overbought) conditions. However, when a person does this, they may spend the money elsewhere, it is difficult to tell when stocks are too high, and the investor may not continue the program. Keep in mind the cyclicality of certain stocks. An example would be utility companies. Some advantages to this method are: The average cost of shares purchased is usually less than the actual market price. The investor eliminates the possibility of buying too many shares when the price is too high. Also, periodic declines in the stock market provide buying opportunities at lower prices. Some disadvantages are: The possibility of liquidating the portfolio when stock prices are low. This could cause a portfolio loss. One way to minimize this danger is to plan to liquidate the portfolio several years before the actual liquidation time. This gives the investor time to pick and choose the best times to liquidate each holding. |
Another disadvantage is that the investor’s income might not be as steady as would be hoped. This could curtail purchases at times that are attractive for additional purchases. Another disadvantage is that the investor might try to time his purchases. This turns him into more of a speculator than an investor. Another disadvantage is that the person may be tempted to use the investment money for something that comes up (e.g. new car, home repair, etc.) and is also quite important. Constant
Dollar System
The constant dollar plan is one where the amount invested in stocks remains constant. A well-diversified portfolio should be used. For example, an investor may have $100,000 invested in stocks. If the value of the portfolio rises a certain amount, say to $110,000, the additional $10,000 would be pulled out and invested in securities other than stocks. Or, the investor may choose a time period interval to pull the funds out. This might be every six months or one year. Conversely, should the portfolio fall in value below $100,000 the investor would add capital to the portfolio to bring it back up to $100,000. Again, this might be done on a percentage basis (say 10%), or on a time period basis (once or twice a year). Some of the advantages of this system are: Stocks are sold when they are rising; and they are purchased when they are declining. The disadvantage to this type of system is that a certain degree of timeliness is involved in determining when to initially set the system up. Also, a period of constantly rising or declining prices doesn't work well. The system works best when prices fluctuate above and below the original level. Constant
Ratio System
This system has the investor maintaining a constant 50/50 ratio in his portfolio between stocks and bonds. As stock prices rise, some are sold and bonds are purchased. As stock prices decline, bonds are sold and stocks are purchased. Profits can be made if stock prices fluctuate above and below the 50% line. There is little evidence that this plan works well in a variety of market conditions For instance, throughout the 1990s, this plan would not have performed well at all. |
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