There are few reasons to be optimistic about the general state of the global economy at present and at times like these it can be difficult to remain confident in the markets. As a long term income investor it can be easier to tolerate significant corrections, but they are certainly an unwelcome phenomenon. It might just be a paper loss, but it is nonetheless a brutal thing to bear. Personally, my long term portfolio has lost almost 30% since the high of late 2007 and frankly there is little consolation in having outperformed the market. Unfortunately it’s likely that it will be many years yet before the market recovers and my losses are erased, but there is one strategy that can substantially shorten the recovery period: dollar cost averaging.
Right at the outset let me emphasise that adding to your holdings purely because they have dropped is not a smart thing to do. There are many justifiable reasons why it may be prudent to accept your losses and move your capital to a better investment. But if you believe in the long term success of a given stock, buying more will drop your average entry price and instantly improve your position. The more you buy at discounted levels, the greater the improvement will be.
But this comes at the cost of gaining wider exposure to the security in question, and it is entirely possible that you go on to lose more money than would otherwise be the case. However, if you remain a believer in the enterprising nature of humanity and the capitalist system, a long term view and a balanced approach will justify this.
Personally I am taking advantage of many of the share purchase plans at present, because I get the opportunity to average down with no brokerage cost at an attractive price. Furthermore, it prevents the value of my existing holdings from being diluted. Just let me emphasise once again; I’m only talking about stocks that I believe have good potential.
The other thing to point out is that you don’t have to add to existing holdings to average down. If you view your portfolio as a whole, the purchase of new shares won’t act to reduce your loss, but it will widen your exposure to the market. This means that you would experience a greater recovery in total capital when the market does inevitably start to recover.
Take for example a portfolio that was worth $100,000 in 2007 and has since dropped to $60,000. To recover the loss we would need to see a massive 66% rise in the portfolio. However, if we added a further $40,000 to the portfolio (and not necessarily into existing shares), it need only gain 40% to recover all capital losses. That’s still a substantial rise, but it does mean that you will be back in the black possibly years ahead of what would otherwise be the case.
Additionally, a greater holding will provide you with greater dividend income. Based on the average drop in dividends, the initial portfolio would be generating approximately $3000 annually after the crash, which represents a yield on your invested capital of just 3%. By contributing the additional capital, the annual dividend stream is likely to be around $5000, giving you a yield of 3.6% on invested capital. This may not seem like a big difference, but it will noticeably shorten your recovery period. It is after all a 66% increase in dividend income.
If you are in the unfortunate position of holding a parcel of shares that have underperformed and have an unattractive or even uncertain outlook you should probably consider the cut and run. It’s not really even a question of whether the stock will recover or not, but whether it has the best potential for recovery. Sure, your shares may well recover from their falls in 5 years time, but it would be better to be invested in a stock that will recoup your capital in half the time.
Ultimately it’s about how hard your capital is working for you: shares are just a means to that end. If it can do better work in another stock, averaging down is not the best thing to do. (Just be cognisant of the fact that if you start switching your allocation around too often you will be trading with your investment capital, not investing it.)
Remember that although additional contributions and/or rearrangement of your portfolio will improve your position, even significant contributions won’t act to eliminate the losses you have already made. Either way you look at it, you have suffered some major losses and barring time travel, there is nothing you can do to change it. But that doesn’t mean we cannot undertake some damage control and act to position ourselves for recovery. Let’s face it, what are your options? If you’ve ridden the market all the way down, selling out of good stocks now will only crystalise your losses. You could transfer your remaining capital to cash, but at present interest rates it will be decades before your losses are regained. Cash may protect you from further downside, it will also prevent you from experiencing any upside
If you’re thrown off the horse you could choose to walk home, knowing you will get there safely even if it takes a long, long time. Or you can get back on the horse and get home much sooner – even if you are thrown off again along the way.
Make the markets work for you