A guide to incremental investing
Fluctuations in the stock market tend to bring out the emotional worst in investors, with people chasing a hot market one minute and running for safety the next. As simple as it seems to say "buy low and sell high," people often end up doing just the opposite.
To escape being lured into emotional investing mistakes, it can help to have a more disciplined system to approach the market. Large moves in and out of stocks -- or any investment -- tend to increase risk. You can take the edge of off market fluctuations if you take a more incremental approach to investing, easing your way in or out of the market in small pieces rather than big chunks.
Here are four examples of incremental approaches to investing.
1. Dollar-cost averaging
This is a widely accepted method of smoothing out market price fluctuations. By putting a consistent amount of money into the market at regular intervals, your average investing cost will reflect neither the highs or the lows of the market. The drawback is that dollar-cost averaging isn't necessarily the most efficient way to enter the market if you have a large sum of money available for investment all at once. It also doesn't really lend itself to providing a selling discipline, or an orderly way to get out of investments. One of the more tactical approaches to investing described below can help overcome these limitations.
2. Price-sensitive investing
This can involve setting price targets on specific stocks, or on the market as a whole. This will allow you to buy when prices dip, and avoid chasing soaring prices. The only problem is that with the market's tendency to rise over time, if you are too stubborn about your targets, prices may run away from you and never come back. This is why you may want to look at valuation rather than just price, as described in the examples below.
3. Yield-based investing
The percentage of a stock's price that is paid out in annual dividends is a straightforward way of looking at valuation. Investing when dividend yields are high will not only help you buy when prices are relatively low, but it will keep your portfolio oriented toward a steady amount of income production. An alternative is to look at earnings yield rather than dividend yield, to help your portfolio capture more growth-oriented stocks.
4. Relative yield valuation
How do you know if a dividend or earnings yield is good or bad? One way is to use an alternative form of yield as a benchmark. For example, with income yields such as savings account interest rates and bond interest at historically low levels right now, stock yields are relatively more attractive -- but only to the point that rising prices don't wipe out that yield advantage.
There is a tendency for people to tout investing systems as ways to beat the market. The truth is that the market is too unpredictable for any system to work quite so magically. However, a disciplined, incremental approach to investing can help you avoid beating yourself with ill-timed moves.