What is Dollar Cost Averaging?

Investing can be tough, especially for those who try to time the market for the best deals and sometimes miss out, but averaging can help overcome these challenges. 

Dollar-cost or in most of our cases, pound-cost averaging is a smart strategy that helps navigate unpredictable markets by automating purchases at regular intervals.

It also encourages investors to stick to a routine of investing regularly.

Market Timing is Very Crucial:

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The consensus in financial circles is that trying to time the market is risky and often ends up being a losing strategy. Perhaps you can time the perfect time to buy into a stock. That still leaves needing to sell at the right time too.

Over the course of time, doing this consistently proves to be very difficult. Financial experts caution against this for several reasons that are easy to understand.

First, predicting short-term movements in the market is tough because it’s influenced by many things like economic indicators and global events. The efficient market hypothesis adds another layer, suggesting that asset prices already include all available information

Making it hard to consistently spot undervalued or overvalued assets. Emotional reactions play a big role in short-term market changes.

Trying to time the market involves making decisions based on predicting how others will act, which can be unpredictable. On top of that, frequently panic buying and selling assets can lead to extra costs and taxes, eating into your overall returns.

Taking a long-term approach has historically been more successful, as it helps you ride out the ups and downs. Trying to time the market consistently is tough for even experienced professionals.

Doing so might cause you to miss out on opportunities for potential gains if you’re waiting for the “perfect” moment to jump in or out. This leads to the natural solution – dollar cost-averaging

So what is Dollar Cost Averaging?

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Dollar Cost Averaging is like putting your money on a rollercoaster ride but in a smart and steady way. Instead of trying to time when to invest based on the ups and downs of the market, with Dollar Cost Averaging.

You decide to invest a fixed amount of money regularly, say every month, no matter what’s happening with the prices of stocks or other investments. This strategy helps you stay calm when the market gets crazy by investing a predetermined sum of money at regular intervals. 

Here’s why:

When share prices are high, your fixed amount buys fewer shares, and when prices are low, it buys more shares, averaging the cost per share over time. This way, over time, the average cost of all your shares becomes more stable. 

Dollar Cost Averaging takes the stress out of trying to predict the perfect moment to invest by ensuring that the sum of money is invested at regular intervals. It’s like setting up a little savings plan for yourself.

Plus, because you’re buying a bit at a time, you’re less likely to make rash decisions based on your emotions, which can be a real challenge in the world of investing.

Anyone can Dollar Cost Average into their investments, whether they have a lot or a little money to invest. It’s a straightforward and accessible way to get into the investing game. 

But keep in mind, while Dollar Cost Averaging is a sensible strategy for long-term investors, it is a magic technique that will guarantee you’ll make a profit. 

Always consider what’s happening in the market, any fees you might pay, and how taxes might play a role when you decide to give Dollar Cost Averaging a try.

Benefits of Dollar-Cost Averaging

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Although this method can assist in risk management, the likelihood of achieving exceptionally high returns is lower. Evaluating the pros and cons of dollar-cost averaging can aid investors in deciding whether it aligns with their investment strategy.

PROS:

Avoids emotional decisions by adhering to a disciplined investment plan.

Using dollar-cost averaging means you invest the same amount regularly, regardless of how the price goes up and down. This way, you don’t let your feelings guide your investment choices. 

Even if the price suddenly drops, you stick to your plan and see it as a chance to get more shares at a lower cost.

Minimizes the Impact of Bad Timing

Putting all your money into a single asset at once comes with the risk of investing just before the market takes a downturn.

For example, if you had invested right before the 2007 market downturn, you would have faced more significant losses compared to investing only a portion of your money earlier.

On the flip side, this approach also means you might not catch the opportunity to invest a substantial amount just before the market starts rising in a bull market.

However, since accurately timing the market is difficult, dollar-cost averaging emerges as a practical strategy, reducing the impact of market volatility.

CONS:

Market values generally increase over time.

One drawback of dollar-cost averaging is that the market tends to rise generally speaking, investing a large sum earlier often performs better than spreading smaller amounts over an extended period.

For instance, consider what happens after investing $5,000 all at once in a stock that annually increases by about 10% at the start of 10 years. 

This would be financially more advantageous than investing the same amount gradually over that time, such as $500 per year. It’s not a replacement for finding sound investments

Dollar-cost averaging doesn’t eliminate all investment risks. Even if you choose the passive approach of dollar-cost averaging, you still need to pinpoint good investments and conduct thorough research. 

If the asset you choose turns out to be a poor investment, you’ll consistently invest in a losing venture. By following a passive strategy, you won’t react to monthly market ups and downs, whether they’re positive or negative while maintaining a steady investment plan. 

As the investment landscape evolves, you may come across new information about an investment that prompts you to reconsider your approach.

Reducing Risk with Dollar Cost Averaging Investment:

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Dollar Cost Averaging can also be used if you’re the type of investor who doesn’t like risky investments. It spreads out the prices at which you buy your investments, making things less risky and effectively reducing the average cost per share. 

Since none of us can see into the future, using Dollar Cost Averaging is a safer bet because it doesn’t depend on guessing what the stock market will do. Instead, focuses on investing a sum of money at regular intervals. 

It’s a bit like having a safety net that protects you from the ups and downs of the market, making your investment journey a bit smoother and less uncertain.

Investing Windfalls:

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When you suddenly come into a big chunk of money, like an unexpected windfall, it’s an emotionally easier move to invest it gradually rather than all at once.

This helps minimize the volatility that comes with the ups and downs of the market by averaging the investment sum of money at regular intervals. Instead of putting everything in at a single moment, you spread out your investments over time at regular intervals.

This way, you’re not trying to guess the perfect time to invest, and it provides a more stable and less risky path to grow your money. It’s tough to see your money fall only days after you put the money into the stock market.

It’s a lot easier to manage mentally if you only invested a little bit of the sum initially and still have more to add as time goes on.

Setting and Forgetting:

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On top of the mental benefits, with Dollar-Cost Averaging, you can set up a plan for regular contributions and then pretty much forget about it. Once it’s all set, your investments grow without needing constant attention.

This approach frees up your time and lets you concentrate on other parts of your life while your money keeps working for you in the background. 

It’s like putting your finances on autopilot, making things more convenient and allowing you to pursue other interests without worrying about the day-to-day of your investments.

Does Dollar-Cost Averaging Work?

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Yes, it can be beneficial but most of the benefits in my opinion are more on the emotional side rather than the practical financial side. So why don’t I do it?

In my opinion, if you are investing in individual stocks, dollar cost averaging doesn’t make sense. If you are investing in index funds or ETFs then lump sum investing is technically a better strategy historically, often outperforming those who pay a sum of money at regular intervals.

Let me explain what I mean.

Individual stocks can be bought at a lower average cost per share through Dollar Cost Averaging, offering a disciplined approach to investing. When you buy an individual stock you are making a statement about its price versus its value.

By buying the stock you are saying that you think that the current price is necessarily below its current value.

Just like when you buy anything, you believe you are getting something of more value than you believe your money is worth – of course this is true because otherwise you would keep the money or buy something else instead!

So what is the purpose of deliberately holding back money that you think is less valuable than the stock you are looking at? You might believe that there is a risk the price will go down lower than it currently is and want to hold off just in case. 

A better way to think about it is to make a plan to decide how much you want to own of it and try to accumulate to that level rather than thinking whether now is the optimum time to buy or whether to hold off. 

It could go up in the opposite direction and then you are averaging up instead. I think that it’s better to think in terms of buying what you want to own. If you have money and think the price is good – buy. 

Don’t regret it afterward as you now own something you wanted, there are going to be a million could ’ves, should ’ves, and would ’ves in life. So as long as you are following your plan or strategy the short-term drop in prices doesn’t need to bother you that you timed it ‘wrong’.

Exchange-traded funds or Index funds

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Now, ETFs are harder to value as there are many components, some will be up some down. So I think buying in increments over time makes sense.

However, I don’t advocate leaving cash that you want to invest lying around for the sake of dollar cost averaging. Just lump sum the amount you want to invest shortly after you get paid.

In a blog post written by Nick Magguilli, he writes “This question comes up a lot when we are chatting with clients.”. I understand the fear they may have around investing this money. There is a lot at stake. 

Hundreds of thousands, maybe millions, of dollars. What if the market crashes right after you invest? Wouldn’t it be better to average-in over time to smooth out any unlucky timing on your part?

Statistically, the answer is no. 

In a paper from 2016, Vanguard found that 68% of the time it is better to invest your money right away rather than buying in over 12 months… The main reason Lump Sum outperforms Dollar Cost Averaging is that most markets generally rise over time.

Because of this positive long-term trend, Dollar Cost Averaging typically buys at higher average prices than Lump Sum.  Additionally, in those rare instances where Dollar Cost Averaging does outperform Lump Sum (i.e., investing a large sum of money at once).

It demonstrates the effectiveness of averaging as a strategy. in falling markets), it is difficult to stick to Dollar Cost Averaging. So the times where Dollar Cost Averaging has the largest advantage are also the times where it can be the hardest for investors to stick to their plan.”

That means, statistically dollar cost averaging (i.e. holding money aside to invest later) is a losing proposition. So while it may have some emotional benefit to doing this way and you feel better about doing it that way, it’s usually going to end up worse off for your finances.

Well, that’s just my thoughts on it anyway, you are of course welcome to disagree and invest in whichever suits you!

In conclusion, attempting to time the market is a challenging task, even for seasoned professionals, and it often proves to be an unreliable strategy. The unpredictability of market movements and the multitude of factors influencing them make it difficult to consistently make accurate predictions.

While there are no guarantees in investing, Dollar Cost Averaging alignment with the principle of disciplined, long-term investing make it a compelling choice for those seeking a reliable strategy to navigate the complexities of the financial markets.

Though at a higher level, it is not as great as it may seem.