A Simple Way to Minimize Your Investment Risk

Before I had saved any money to invest I started a fantasy trading account where I purchased investments with fake money to see how I would have fared in the financial markets. I purchased $100,000 of stocks in well-known American companies and was eager to make my first fake million. This was around 2008 right before the markets tanked, so needless to say it was a good lesson in humility. My $100,000 fake account dwindled to approximately $60,000 within a couple of months. It was probably one of the cheapest lessons I have ever received that I still reflect on today. My obvious blunder was that I entered the market with my investments all at once instead of over a long duration of time.

The phrase “timing the market” refers to trying to purchase investments while they are at their lowest price in hopes that after you have bought them they will skyrocket. The problem here is it’s pretty difficult to determine when an investment is at its low point. There are thousands of investment firms attempting to calculate the same thing with a lot more resources and brains than you or I could ever have. Instead of going head to head with them I use a strategy called dollar cost averaging.

I first learned about the power of dollar cost averaging in David Chilton’s book The Wealthy Barber. The basic premise of dollar cost averaging is that by consistently purchasing investments in small increments over an extended period of time you will considerably reduce your exposure to large drops in the market. This investment strategy does not always ensure the largest return on your investment, but it will reduce the over risk in your portfolio.

Let’s use my fake money scenario of $100,000 to illustrate how dollar cost averaging would have saved me fake tens of thousands of dollars. I purchased $100,000 of various American and Canadian investments in June 2008 (right around the peak of the markets) and then over the next 6 months it plunged to $61,000:

DateInvestmentFair Market ValueProfit/(Loss)
June 2008$100,000$100,000$0
July 2008$100,000$92,400($7,600)
August 2008$100,000$93,700($6,300)
September 2008$100,000$80,000($20,000)
October 2008$100,000$66,000($32,000)
November 2008$100,000$63,000($37,000)
December 2008$100,000$61,000($39,000)

 

As you can see I lost $39,000 on my investments over a brief six year period. Now this was an extraordinary period of losses, but it happened. Now had I used dollar costing average and invested evenly over the six month time frame the portfolio would have looked something like this:

DateInvestmentFair Market ValueProfit/(Loss)
June 2008$14,000$14,000$0
July 2008$28,000$26,936($1,064)
August 2008$42,000$41,300($700)
September 2008$56,000$49,546($6,454)
October 2008$70,000$55,706($14,294)
November 2008$84,000$67,606($16,394)
December 2008$100,000$81,926($18,074)

 

Using dollar cost averaging would have saved me approximately $20,000 of my portfolio during this down swing in the market; it would have also allowed my portfolio to rebound much quicker. Using this investment strategy reduces losses during decreases in the market, however, it also reduces profits during increases in markets. This can be perceived as the cost of reducing risk.

There are multiple methods to reducing risk within your investment portfolio but few are as simple and effective as dollar cost averaging.

When I first started investing I continually reviewed market positions and the fair market value of my investment portfolio. Since reading The Wealthy Barber my approach has become much more laid back. Yes, there are going to be up and down swings in the market but I’m content to sit back and keep buying knowing in the long run that money will grow.

Facebooktwittergoogle_pluspinterestby feather

One comment

  1. Thank you for sharing. It’s very useful. I’d like to hear more from you.
    Mathieu Lebrun recently posted…Mylène Martin CharbonneauMy Profile

Leave a Reply

Your email address will not be published. Required fields are marked *

*

CommentLuv badge