Ultimately, each investor should carefully weigh their options, and decide based on their individual investing needs.
The Zions Direct investment center consists of 13 licensed representatives who together take thousands of phone calls every month from individual investors. While each of these calls is unique, each month lends itself to over-arching themes patched together by common concerns. This piece is intended to answer some of the more reoccurring questions my colleagues and I have heard over the previous month. During May, we had calls about both dollar-cost averaging and stock splits.
Question 1: What are the advantages of dollar-cost averaging versus a one-time investment?
Dollar-cost averaging is an investment strategy in which an investor divides a large lump sum into equal parts and then invests it into a fund at fixed intervals for typically 6 to 12 months. The purpose of dollar-cost averaging is to average the cost of shares, as an investor is able to buy more shares during periods when prices are low, and less when prices are high.
For example, imagine two scenarios in which an investor receives an inheritance of $24,000. In scenario one, the investor decides to invest it as a lump sum into a mutual fund at $25 a share, receiving a total of 960 shares. For scenario two, imagine instead that the investor uses the dollar-cost averaging method. If the investor divides the inheritance into 12 equal investments of $2,000 each, and invests over a year period at prices of $25, $22, $21, $19, $22, $27, $25, $30, $27, $24, $23, and $20, the investor receives 1027.424 shares, for an average cost of $23.36 per share. In this scenario, the investor receives more shares creating a lower cost basis (i.e., average cost).
Dollar-cost averaging is not without its critics, though, as the opposite of the above scenario, which would be a rising average cost, is just as likely. Another criticism of dollar-cost averaging is that while the investor is waiting to invest the cash, he or she is losing out on potential dividends. However, some investors still choose to invest using this method because by making periodic investments they mitigate the risk of buying right before a drop in the market and taking a large loss. Ultimately, each investor should carefully weigh their options, and decide based on their individual investing needs.
Question 2: What is a stock split? What is a reverse stock split?
Every company wants its share price to rise, but sometimes the price will rise a little too high for its sector, pushing it out of the buying power of the everyday investor. In this situation, the company may decide to perform a stock split. In a 2-for-1 stock split, each shareholder will be given two shares for every one share he or she holds and the price will be cut in half. For instance, if a shareholder has one share of stock worth $200, after the split the investor will have two shares of stock worth $100 each. For the company, this will double the number of shares outstanding, but it will have no impact on the market capitalization, which is the total value of all stocks outstanding.
Conversely, if a company feels its shares are trading too low, thereby negatively affecting investor sentiment, it can consolidate its number of shares outstanding through a reverse stock split. In a 2-for-1 reverse split, for every two shares an investor holds he or she will receive one. For instance, if a stock is trading at $1 per share and an investor has 200 shares, after the split the investor will only have 100 shares, but each will be worth $2. In either case the investor holds $200 worth of stock. Similar to the stock split, the company's market capitalization remains the same.
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Savannah Wade is an employee of Zions Direct and a registered investment representative holding Series 7 and 63 licenses. Zions Direct is a wholly owned non-bank subsidiary of Zions Bank