There’s an old saying among investors. It goes: “time in the market beats timing the market.” As applicable in today’s complex financial markets as ever, this principle suggests that most investors should start getting exposure to assets immediately rather than waiting for the “perfect” entry point.
Dollar-cost averaging exploits that principle. While it’s entirely appropriate for investors at all experience and skill levels, it’s particularly well suited to individual self-directed investors who don’t have the time or the wherewithal to nimbly navigate the market’s unpredictable ups and downs.
You don’t need a huge account to get started. You only need access to some investable cash that you probably won’t need to use anytime soon, an investment account, and a source of income or other funding that will allow you to continue investing in the future.
You’ll also need to identify a stock or other investable asset that you believe (after conducting thorough research, of course) has the potential for long-term upside in its price.
And, of course, you’ll need to know the basics of dollar cost averaging.
What Exactly Is Dollar Cost Averaging?
The U.S. Securities and Exchange Commission, or SEC, states that dollar cost averaging involves investing your money into an asset at “regular intervals” and in “equal portions.” The SEC also specifies that one would continue to do this “regardless of the ups and downs in the market.”
Perhaps that last phrase could be modified to “regardless of the ups and downs of the price of the asset you’re purchasing” since not every financial asset follows the markets.
In any case, there are a number of moving parts here, so let’s break them down one at a time.
First of all, “regular intervals” could mean that you’re putting money into the same stock or another asset once a month or perhaps once every two weeks since that’s how often many people get their paychecks. These are common time intervals to invest with dollar cost averaging, but you can pick whichever interval is right for your circumstances.
Another part of the equation is that you’d be investing in “equal portions” meaning you’d invest the same, comparatively smaller amount of money into an asset instead of putting the total amount into it all at once.
Let’s say you eventually wanted to invest $20,000 into XYZ stock. Sure, you could just buy $20,000 worth of XYZ stock shares immediately, but that’s not dollar cost averaging.
Instead, you could take $100 out of your paycheck every two weeks and buy $100 (or as close as possible) worth of XYZ shares with it.
Note: the idea is to buy the same dollar amount of the asset, not the same number of shares/ounces/tokens/etc.
Finally, don’t ignore the “regardless of the ups and downs” part of the formula. Even if the asset you’re buying on a regular basis is volatile, dollar cost averaging means suppressing your emotions and just buying the $100 worth of XYZ stock (or whatever amount and asset you’ve chosen) on schedule, as planned, no matter where the stock moves.
What Are the Advantages?
There are a number of advantages of dollar cost averaging, as opposed to pouring your investable money into an asset all at once.
For one thing, you might want to invest $20,000 in XYZ stock, but you might not have all of that money available now. So, dollar cost averaging allows you to contribute what you can afford until you eventually invest the entire amount.
Second, the strategy offers simplicity and consistency, which will benefit many beginners and intermediate investors who aren’t ready to try out more complicated strategies (which aren’t necessarily superior). Dollar-cost averaging doesn’t require any fancy formulas or constant staring at the computer screen.
Your broker might even allow you to automate your regularly scheduled contributions, thereby making an easy strategy even easier.
Furthermore, dollar cost averaging helps to prevent investors from falling into the “time the market” trap. When an asset price falls, you might get fearful and refrain from investing in it. Or, after the price goes up a lot, you may be tempted to rush in and buy it. However, this type of behavior runs counter to the principle of buying at low prices and selling at higher prices.
Dollar-cost averaging, in contrast, encourages you to ignore the temptation to “chase” the asset’s price moves, as you’d just stay consistent with the schedule and the fixed dollar amount.
Here’s how it works
You’ll be purchasing more shares (or ounces, tokens, etc.) of an asset when the price is low and fewer shares when the price is high.
If XYZ stock is up to $10 when it’s time to make your regularly scheduled $100 purchase, you’d only be buying 10 shares of the stock at that high price.
Later on, if XYZ stock fell to $5 and it’s time to make your next purchase, you’d be buying 20 shares of the stock at that heavily discounted price.
Because you’d be buying more at lower prices and less at higher prices, your average purchase price of the asset can go down: hence the name dollar cost averaging.
The objection that more purchases mean more fees doesn’t necessarily apply in an era of no-commission trading. However, be sure to check with your broker to determine your particular commission and fee structures.
What Are the Risks?
Dollar-cost averaging imposes discipline and largely removes timing risk: the risk of buying at the wrong time or falling into the trap of buying high and selling low.
That’s not the only risk in investing, of course. The main risk of dollar cost averaging involves asset selection.
Stock markets have always risen over time. That doesn’t mean every stock rises over time. Some companies fall and fail and never get back up. No strategy will protect you from the risk of simply investing in a company that doesn’t have a future.
If you don’t have the expertise to select individual stocks with confidence, you can apply the strategy to a mutual fund or ETF, or even an index fund. This provides a level of diversification that insulates you from the risk of simply selecting the wrong asset.
Above-Average Returns Are Possible with Dollar Cost Averaging
Could you make more money with an immediate, lump-sum investment instead of dollar cost averaging? It’s possible in some instances, but dollar cost averaging helps investors stay disciplined and buy more when prices are low, and less when prices are high – a policy that has certainly stood the test of time.
It’s a strategy that some people use in 401(k) and other retirement-appropriate types of accounts, but it might be worth trying in other long-term portfolio types as well. So, for a keep-it-simple approach that might offer enhanced returns with less emotional involvement, consider putting your dollars to work with dollar cost averaging.
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