A stock market correction can be scary for many investors, but it doesn't have to be. Not only should a correction not be feared, but it should be looked at as a chance to pick up more shares of industry stalwarts like Bank of America and ExxonMobil at a discount. Even if the market continues to decline, with the concept of dollar-cost averaging, you can mathematically guarantee that you'll build long-term positions at a good price.
How dollar-cost averaging worksDollar cost averaging is an investment strategy that involves building positions in your stocks over time by investing equal dollar amounts at specific intervals. For example, instead of investing $2,000 in a certain stock all at once, a dollar-cost averaging strategy could involve investing $500 every three months instead.
With this strategy, you'll buy more shares when prices are low and fewer shares when prices are high. For example, if you make $500 investments in a certain stock every month, and the share price is $50 right now, you'll buy 10 shares. However, if the share price drops to $45 by next month, you'll be able to buy 11 shares. In other words, more of your shares are purchased when the stock is cheaper. Over time, this produces a better-than-average share price.
But wouldn't it be better to just buy all of your shares when prices are cheap? Well, sure it would, but timing the market is virtually impossible to do. A stock could look "cheap" at $50, but continue to fall. By averaging into a position, you eliminate the risk that comes with trying to pick the best time to buy.
To illustrate the power of dollar-cost averaging, let's take a look at a real-world example of how this works by using one of my favorite stocks that has dropped throughout the past year --ExxonMobil.
If you had invested $10,000 in ExxonMobil one year ago, you would have purchased 101 shares at a price of about $98.50, and you'd be sitting on a 30% loss right now. On the other hand, if you had made a $2,000 purchase every three months instead, here's how it would have turned out.
There are a few things to notice here. First, your average purchase price per share would have been $86.95, which is below the stock's average price at the points when you bought shares. In fact, dollar-cost averaging always results in a better-than-average purchase price, thanks to the laws of mathematics.
Additionally, not only would your overall "loss" be limited to 21%, but you would now own 115 shares altogether, putting you in a better position to make money in the future when the market rebounds. That's why dollar cost averaging is an important concept for long-term investors to know and use -- especially during the tough times.
A long-term example of how dollar-cost averaging works for youArguably, one of the worst investing moves you could have made in the past decade would have been to purchase shares of some of the big banks such as Bank of Americaprior to the financial crisis.
Bank of America's stock peaked at approximately $55 per share in 2006, and subsequently plunged to less than $3 at the depths of the crash. Even to this date, Bank of America's share price has only managed to recover to $16.43 (as of this writing).
If you had invested $10,000 in Bank of America on January 1, 2006, you would have purchased 213 shares, which would now be worth just over $3,500 a 65% loss.
On the other hand, if you had decided to invest $1,000 per year for the next 10 years, here's how your investment would have played out. For simplicity's sake, I'll use the share prices on the first trading day of each year.
Think about this for a minute. Not only would you now own more than three times the amount of shares, but you would actually be sitting on a 7% gain for your overall investment -- not including any dividends you received along the way. Thanks to this disciplined approach, less than 10% of your total shares would have been purchased for more than $40, and the vast majority would have been purchased at "discounted" post-crash prices.
The takeawayInstead of looking at a stock market correction as a reason to panic, think of it as a gift to your long-term strategy. After all, in order for dollar-cost averaging to work, you need to buy some of your shares when prices are high and some when prices are low. Corrections like this one are a great time to do the latter.
The article With This Investment Strategy, Market Corrections Don't Have To Be Scary originally appeared on Fool.com.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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