Why I love it when markets tank

Dollar cost averaging (DCA) can help you weather a bear market and make money in the long run no matter how the market performs.

I just fired up the local news website and saw that the Dow, that oddly insufficient measure of US financial health, dipped 665 points over the week, or about 3% of its total value.

Putting aside a discussion about why we only seem to care about 30 large companies in America and not a larger spread, what’s inescapable is that some people, myself included, theoretically, lost a lot of money today.

And as I do when this happens, I smiled. Not because of some kind of sadistic/masochistic urge, I assure you, but because I benefit. And almost everyone does too, even if they don’t know it.

Buy whenever, sell later

Buy low, sell high; that’s the mantra. But that’s a gross oversimplification. Of course you don’t want to lose money on a transaction if the purpose is to make money on it, but taken to an extreme this view can cause people to lose sight of both the bigger picture and the day-to-day picture as well.

For most of our lives, if we’re putting money into any investment product (and I believe that you need to be an investing expert) we’re doing it not at one time, but in small increments over a long period of time. With so many investment points, and an uncertain plan for withdrawal/usage (as most of us don’t know the details of our own retirement) can any of us know when we’re buying low or high?

Of course not.

Luckily, it doesn’t matter. And the reason why it doesn’t matter is due to the specifics of sustained, predictable investment, namely: when you purchase something that rises in value, you benefit, and when you purchase something that falls in value, you buy more of it, so you benefit again when it rises in value.

This is known in the trade as dollar-cost averaging (or unit-cost averaging, if we’re being non-US-centric).  And it’s why we need not freak out when our markets go into a tailspin.

Tiddlywinks

Let’s take an example. Say you have $100 to spend each month, and you purchase units of the Tiddlywinks mutual fund. (Ticker: TDLWX) The fund starts out at $10, takes a nosedive mid-year to $5, and then recovers to $9 by the end of the year. See here:

With this in mind, you can buy the following units:

You might be biting your fingernails midyear, wondering what will become of your beloved fund. By the end of the year, you’re still “down”, as your fund has lost 10% of its value. Cue panic.

But let’s look at the numbers. By the end of the year, you purchased 179.14 units of Tiddlywinks. Which at $9, is worth $1612.26.

But at $100 a month, you only spent $1,200! That means that instead of losing 10%, you’re up 34%! Look at you!

And this is assuming that Tiddlywinks will never reach its earlier heights. If it does, then you’re up even further.

Now, I grant that this is a fictitious example, but the fundamentals hold whether we’re dealing with a real fund or a fake one. Markets go up and down, of course, but we see here that the downturn actually benefited us. Had the fund stayed constant, we would only have $1,200 in our example, and not $1612.26.

Retirement age concerns

What if you’re nearing retirement age? Do you freak out then?

I still say no. And the reason is that dollar cost averaging works in your favor on the withdrawal side too, as you’re not taking everything out when the markets are down. They will go back up again. I admit that this was pretty hard to believe back in 2009 (and I imagine in other downturns too). And while past performance is no guarantee of future results (as they say), so far, 100% of all of the downturns in recent history have been followed eventually by a larger upturn. Don’t panic.

So the next time you see the news saying how the markets are tanking, don’t freak out, don’t sell everything, don’t give up on money. In fact, don’t do anything but go about your day.

And perhaps smile.

But enough about me. Do you care about the ups and downs of the market?