Reinvesting Profits
The first technique worth considering is the reinvestment of profits, a form of compounding your return. A study of the effects of compound interest makes the point. When you leave earnings to accumulate, the effect is dramatic. The same is true in investing.
Mutual fund investors can easily apply the principle of compounded return simply by instructing management to reinvest all dividends, interest, and capital gains in additional shares. This is one of the reasons mutual funds are widely popular investment vehicles; the ability to leave funds at work in compounded, reinvested form, adds up to ever-increasing profits over time. Direct ownership of stock does not provide for the same universal level of convenience. Many corporations allow stockholders to reinvest dividends in partial share purchases often without additional brokerage fees. Look for stocks offering DRIPs (dividend reinvestment plans), direct ownership makes reinvestment difficult.
The importance of reinvesting your capital and keeping it at work should not be ignored. Just as the interest you pay on mortgages and other loans has a compounding effect, so does investment earnings. In the long term, it is the accumulated benefit of keeping capital at work that adds up to significant profits, rather than the regular deposit of additional funds. The combined effect of putting money aside and reinvesting earnings is the real answer to wealth building over a lifetime.
Dollar Cost Averaging
One good method for establishing and managing an ongoing program of regular investing is dollar cost averaging. This means that the same amount of capital is invested in a portfolio at regular intervals,
212 Mastering Fundamental Analysis
regardless of the share price. Dollar cost averaging tends to average out the overall share price paid for securities. When the stock's market price is rising, the average share price is invariably lower than the current market price. And when the stock's market price is falling, the average share cost under dollar cost averaging is continually reduced, through dollar cost averaging, to reduce the overall paper loss.
Dollar cost averaging is popular because it reduces the risk of loss while giving investors a formula for recurring investment. It works well in situations where the actual dollar amount does not matter, such as in mutual funds. In fact, most funds specify a minimum investment amount, and that amount buys whatever number of fractional shares are available at the current price. The combination of dollar cost averaging and dividend reinvestment is appropriate as well as popular in the mutual fund industry.
KEY POINT
Dollar cost averaging is a technique for regular, disciplined investing. It enables you to overcome short-term tendencies to vary an otherwise sensible investment strategy.
The direct purchaser of stock faces a problem with dollar cost averaging. Unless you are willing to pay higher trading fees for odd lot purchases, dollar cost averaging is not a very practical way to invest. Because of the trading mechanisms and practices of the market, direct purchasers of stock are more likely to purchase round lots of stock rather than trying to regiment their buying practices. While dollar cost averaging has a certain mathematical appeal to the mutual fund investor, it creates problems in the direct purchase of stocks.
