I know the stock market can be a frightening place. You work hard, diligently save, control your costs, and then wake up to find tens, or even hundreds, of thousands of dollars melting off your brokerage or retirement account statements. If this describes you, I have great news! I’m going to share with you the number one secret that can help you cut years off the process of rebuilding your equity and put you ahead of the competition.
More than a hundred years of academic research has proven that it works.
A Powerful Combination: Dollar Cost Averaging & Dividend Reinvestment
Investors who are prone to panic are fond of point out the fact that it took more than twenty years for the stock market to return to its previous high after the last great crash. What they don’t understand is that if you had been dollar cost averaging as the market fell, you would have made several hundred percent on your money by the time the Dow Jonesgot back to break even levels. Think about that. The market just got back to even, yet you would be sitting there with several hundred percent more wealth in your pocket than the guy that had simply bought and held. This is why you hear many experts tell you that it is irresponsible to simply dump a large amount of money into the market at any one time.
By consistently investing regular amounts of money at fixed intervals in low-cost broad based index funds or individual stocks (if you have the experience and knowledge to select individual companies), you can lower your overall cost basis.
Each week or month, your fixed dollar investment buys you more absolute shares of stock or a mutual fund. That is, you bought more future profits and dividends for the same amount of money.
Reinvested dividends just accelerate the process, according to the research of Wharton finance professor Jeremy Siegel. As the stock falls, the cash dividends that you reinvest buy you more shares. Each of those additional shares generates dividend income. This is a self-reinforcing cycle that can help turn a respectable profit on an investment even if the market price of the stock is slightly lower than or break even with your cost basis.
An Example from My Own Portfolio
Four and a half years ago, I bought 105 shares of U.S. Bancorp in one of my retirement trusts simply as an experiment in dividend-based stocks. I paid $27.29 per share and had a total cost basis of $2,865.45. Today, thanks to reinvested dividends, I own 124.36474 shares, or nearly 20 shares more than I originally purchased. The stock has crashed (along with everything else) to $23.62 as of the close of the markets on November 19th, 2008. Yet, despite a drop of 13% in the stock price over the 4.5 years since I’ve owned the bank, I actually show a slight gain on the investment. In today’s market environment, where 50% losses are not uncommon, that’s a fantastic showing. Even better, the quarterly dividends are picking up more shares as the stock falls, accelerating the process of future gains by lowering my cost basis.
But here is where it gets really interesting. If the stock were just return to my original cost basis of $27.29, I would actually show a gain of 18.44%! You can read all of the details inA Real-Life Glimpse Into My Dividend Portfolio.
This double combination of dollar cost averaging and dividend reinvestment, when coupled with strong businesses that generate healthy returns on capital, is one of the greatest protections against long-term losses in the stock market. You may have a bad year (or three), but over time, they can help push you towards profits faster than anything else you could do.