Best Strategy For a Bear Market: 2022 has seen one of the most extraordinary selloffs in the history of the stock market.
Following a robust recovery from the lows of March 2020, stocks are once again plummeting from their previous highs.
Ironically, the best strategy for such bearish conditions is also one of the simplest, most common approaches to investing. Here’s what you need to know about dollar-cost averaging (DCA) and how it can help your portfolio in a bear market.
How Does Dollar-Cost Averaging Work?
Dollar-cost averaging involves investing a set amount of money into a stock or index at regular intervals, such as monthly or quarterly.
For instance, an investor planning to purchase $1,000 worth of Apple (NASDAQ:AAPL) stock over a year using a DCA strategy could choose to invest $250 each quarter or $83 each month.
The goal of dollar-cost averaging is to smooth out volatility and decrease the likelihood of investing a lump sum at market highs.
Over time, DCA allows investors to buy at both high and low prices, effectively reducing the impact of short-term volatility on long-term performance.
This also removes the temptation to time the market, which frequently backfires.
Pros and Cons of Dollar-Cost Averaging
The most obvious upside of dollar-cost averaging is that it allows you to invest money consistently in all kinds of market conditions. This means that there will be times that you will buy depressed shares that could deliver outsized returns when the market recovers.
Provided you’re investing in a solid company, DCA will let you steadily build up your stake and realize compounded returns over time without having to worry about day-to-day market changes.
DCA also takes a great deal of the emotion out of investing.
By planning to invest a set amount of money at a predetermined interval, you can largely eliminate emotional pressures like fear of missing out. With a DCA strategy, you have a simple, actionable plan to follow that doesn’t depend on external price signals. This is one of the reasons that dollar-cost averaging is widely recommended to new investors who otherwise might get caught up in the infamous boom-and-bust cycle of the stock market.
Like any investment strategy, though, dollar-cost averaging does have its downsides. The reduction in volatility cuts both ways, reducing the returns that you might see from a lump sum invested when a stock was substantially undervalued.
Dollar-cost averaging also forces you to hold cash you plan to invest for a longer period of time, which may reduce overall returns.
Can You Use DCA For Any Stock?
A DCA strategy can be used for any stock. However, it’s best to use this strategy when investing in companies that have good long-term growth prospects.
A company that is consistently overvalued may never become a good investment, even with the effects of temporary volatility removed. As with all other types of investing, it’s important to do your due diligence before buying a specific company using a dollar-cost averaging strategy.
It’s also worth noting that you can use this strategy when investing in index funds. By combining DCA with index investing, you can create an almost completely passive investment plan.
While this approach won’t allow you to take advantage of the higher returns of successful stock picking, it is arguably the simplest and most hands-off way to build wealth over time.
Why Does Dollar-Cost Averaging Work Well in Bear Markets?
Bear markets represent the ideal conditions in which to invest using dollar-cost averaging. When share prices are depressed or heading downward, you’ll be able to buy more shares for the same amount of money. This approach allows you to invest into a down market without attempting to time the bottom of the market.
2022’s sharp selloff provides several examples of stocks that could be purchased in increasing quantities month-over-month using a DCA strategy.
Let’s use streaming service provider Roku (NASDAQ:ROKU) to illustrate the power of dollar-cost averaging in bear markets.
Suppose you chose to invest $500 in Roku stock at market open on the first trading day of every month in 2022. The historical prices at which you purchased your shares so far would be as follows:
- January 3: $230.63 (2.17 shares)
- February 1: $168.75 (2.96 shares)
- March 1: $139.03 (3.60 shares)
- April 1: $126.50 (3.95 shares)
- May 2: $92.67 (5.40 shares)
- June 1: $95.03 (5.26 shares)
- July 1: $82.54 (6.06 shares)
As you can see, dollar-cost averaging going into 2022’s bear market would have consistently reduced your cost basis on Roku stock.
The final number of shares you’d have today would be 29.40, compared to just 15.18 shares you could have purchased by investing the entire $3,500 on January 3. In this case, DCA nearly doubles the shares you would have in your portfolio.
Provided the intrinsic value of the business remains the same, buying shares at lower prices in volatile market conditions will also significantly increase your overall returns. Roku, for instance, has a median 12-month target price of $150.
Assuming the stock reaches this level, you’d be in the red on shares purchased in January and February. The shares you bought from March onward, however, would all generate positive returns. If you had invested the lump sum in January, your 12-month returns would be sharply negative.
Similarly, the early months of 2022 would have been an excellent time to invest in index funds using dollar-cost averaging. The first six months of this year were the worst for the S&P 500 since 1962.
Investors who used dollar-cost averaging to buy the S&P during this time are almost certain to see strong returns when the market eventually recovers.
Needless to say, dollar-cost averaging doesn’t always produce such positive results. The first half of 2022 has been extremely unusual, leaving investors with many opportunities to buy stocks at significant discounts. Even during bullish market conditions, though, the DCA strategy can be a good way to level out volatility and consistently invest in indexes or companies that have room to continue growing over many years.
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