We often see days where the Dow will surge ahead 200 or even 300 points in a single session. Then, the very next day, the same Dow will fall 150, 200, or more. The volatility is enough to make some people throw up their arms in disgust. Are the rate cuts over? Is there any more upside? Is a recession looming?
Imagine for a moment that you find the perfect companyâ€”it’s trading at a reasonable value, the growth prospects are amazing, the management looks terrific and you’ve poured over the financial reports and found a strong balance sheet, mouth-watering cash flows and hardly any debt. It looks like a buy! So you pull the trigger and buy a whole pile of shares. Then, a month later, you check back and the stock is down.
That could be a good thing.
What? Am I crazy? No way. Check out my example of how accumulating shares over the long run can actually help the average investor make stellar returns in the long run.
Let me state straight away that this is slightly different than dollar cost averaging, because in that model, you are buying more shares as the price drops. Here, we are just buying the same number of the shares but the price never falls.
For the example above, let’s use a share price of $10 so 100 shares is $1,000. You buy 100 shares next year, and every year for four more years. And, all during that time, the share goes up by 10% per year. Your investment would look like this:
Year 0: 100 shares costs $1,000
Year 1: 100 shares costs $1,100
Year 2: 100 shares costs $1,210
Year 3: 100 shares costs $1,331
Year 4: 100 shares costs $1,464
So now, at the end of Year 4, you own 500 shares and paid $6,105. The shares, during that time, went up 10% per year for 4 years.
But what if the shares flatlined for 4 years instead, and then jumped up 40% all at once? We would have accumulated $500 shares at a cost of $5,000 and then the whole group of shares would have jumped 40% in value. That means that your $5,000 would be worth $7,000 instead of the $6,105.
Is this plausible? Does that sort of thing happen? Yesâ€”all the time. Companies fall off the radar screen of the big analysts, or many smaller companies take 5 years (or more) to even get on the radar screen of the big firms. So you could, in theory, be accumulating shares for years at a flatline price and then suddenly watch as it takes off.
This sort of strategy is also called “hockey stick” investing as you purchase shares along the shaft of the stick (a long, straight, flat line) and then suddenly ZIP! The shares pop up in price and the general world picks up on the great value of the company.
Instead of displaying an obscure, small and risky company, let’s go with a solid ETF that performed exactly the way described above: The China 25 Index FXI ishares ETF. For all of 2005 it traded flat. In 2006, it traded a little higher, and in 2007 it broke out with an 88% YTD return. If you had been accumulating before the break out, you would be swimming in returns right now.
That’s the trick: find the shaft of the hockey stick and accumulate, and enjoy the ride when the investors pour in… even if it’s years later. Some huge gains are made when investors ride that one good year of returns far off in the future.