How to Average-In: Tempur-Pedic, InFocus, Disney

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

I had a question from a reader last week that intrigued me all weekend. He felt that if his time horizon is 20 years or longer, shouldn't he be averaging into the market right now?

I contemplated this over the weekend as I sat poolside with the new George Pelecanos novel (for fans of crime fiction who have not read him, do so now -- he is the master of the art) and enjoying an unusual warm, low-humidity weekend. The answer I came up with is yes, if you have that long a time horizon, I probably would advise that strategy.

I have two caveats to this. One, as Warren Buffett once remarked, if you cannot stand a 50% drawdown, do not invest in the stock market. The second caveat is that rolling 10- and 20-year terms that include the start of a recession will have much lower than average stock market returns. History tells us you will have a positive return over a 20-year investment in the stock market. It does not guarantee that it will be a great return or that you will not experience significant drawdowns.

We are down around 20% from the highs, but that does not meant we have to stop here and go up. The current economic and earnings outlook remains gloomy at best. Standard & Poor's predicts a recession that it expects to last at least through the first half of 2009. That tells me a bottom is at least six months away, even for an anticipatory stock market.

In the collapse of the Internet bubble, we saw prices fall over 50% from peak to trough between 2000 and 2003. The economy and financial situation are much worse right now, and to complicate matters further, the Fed has bungled badly. Real estate is not done falling, and credit will remain tight for some time to come. I can easily see a total decline that reaches that level.

I would probably wait to start averaging in, but no one, not even I, can exactly predict a long-term bottom in the stock market. If you have cash and are committed to this strategy and mentally prepared for drawdowns, I would put 10% to work today. Then, each time the market falls another 10% from the highs -- about 150 S&P 500 points or 1,400 Dow points, I would invest another 20% of my cash.

Any day that sold off by 2% (30 S&P points or 280 Dow points) of the high-water mark, I would invest another 5% of my capital. I would follow this model until I was fully invested, or until the real estate market stabilized and credit eased, allowing the market to put in a real bottom. At that point, I would go all in.

Via Funds or Stocks

Most investors will choose one of two methods for investing, depending on the size of the bankroll. Use whatever approach you decide is appropriate for you, whether stocks or mutual funds. Being me, I would focus on buying value. If you are using funds, look at some of the great value funds run by masterful investors. Offerings from Tweedy Browne, Third Avenue, FPA Funds or the Keeley Funds are among those that leap readily to mind. These are the funds that have historically followed strict value investing principles and have done well historically.

After the second 10% drawdown, I would begin to add a little bit of the high-growth funds. Although they can be very volatile, they tend to be spectacular coming off a market bottom and remain so well into a new bull market. I would, however, keep at least a 70% tilt in favor of value.

If you are using individual stocks, I would initially focus on those stocks that fit into the too-cheap-not-to-own category. I have written about some of these groups recently. I believe the furniture stocks, the data storage group and selected well-financed REITs fit the bill nicely.

Names I like here include Tempur-Pedic ( TPX), Seagate Technology ( STX) and Hersha Hospitality ( HT). Stocks such as InFocus ( INFS), Hilltop Holdings ( HTH) and Adaptec ( ADPT) fit the bill nicely.

When you reach the second 10% decline from market highs, I would begin to add the blue-chips such as Disney ( DIS), Cisco ( CSCO), Johnson & Johnson ( JNJ) and other companies that are the class of their industry groups.

Should there be a third drawdown, I would add the high-growth stocks such as those on the Value Line list of 1-ranked stocks. On 2% down days, I would add to the positions that have fallen the most during that trading day.

Averaging in can be a great strategy, provided you have the right mind-set. You have to be committed to a very long time horizon. You must be prepared for your original positions go down in price, sometime significantly so. Start with a very conservative position and get more aggressive as the market declines further. Be flexible and willing to add capital on large down days rather than sticking to a fixed schedule.

Using this approach should give you a substantial price advantage as opposed to jumping in too soon, and it should allow you to grow your nest egg over the long term.

This was originally published on RealMoney on August 5, 2008. For more information about subscribing to RealMoney, please click here.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider InFocus, Hersha and Adaptec to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices. At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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