If someone tells you when the perfect time to invest in the market is, they are likely lying. Market timing is always a popular topic, especially with the recent drops in the market. If you recently acquired excess money from a bonus, cashed out an investment, sold a business, etc., you may question how to invest it. Instead of timing the market with all your newfound money, using a dollar-cost averaging investment strategy could help reduce the risk of buying before the market drops.
What is Dollar-Cost Averaging?
In a simplified manner, dollar-cost averaging (DCA) is the process of buying the same investment over multiple time periods. Instead of buying an investment for $120,000, an investor would buy $10,000 of that same investment each month for one year, for example. There is no hard and fast rule as to the length and amount of a given DCA strategy. The investment itself, the investable amount, your risk tolerance, objectives, and goals would play into determining the exact strategy suitable for you.
Dollar-cost averaging is most commonly seen among investment accounts investing in the stock market, though you can find the strategy in nearly any market. The most glaring example is the monthly contributions into someone’s retirement account. For many people, they contribute thousands of dollars each month to their 401k account through payroll. Those funds are then automatically invested each month, creating an indefinite DCA strategy.
Why is this strategy helpful, and not just a waste of time? Because you do not know what the price of the investment will be in the future. From a long-term growth perspective, investors expect the price to rise by the time they sell it, with some inherent risk that it will not. Otherwise, you would never buy the investment in the first place. However, from a short-term perspective (days, weeks, months, even years), the price of certain investments can fluctuate dramatically.
When Does Dollar-Cost Averaging Work?
To make a profit, the goal is to buy low and sell high. The fundamental nature of investing for growth is the degree of confidence that your purchase price will be lower than your sale price in the future. The degree to which you are not certain is called risk. The higher the risk, the less likely you are to make a profit. Certain investment strategies could help reduce that risk, but cannot ultimately eliminate it.
In the example of investing in a stock each month for a year, you can begin to see where the dollar-cost averaging strategy gets its name. Since the stock price constantly changes over the course of the year, there will eventually be 12 different purchase prices. If the average price of all 12 months is less than the price of the first month, then DCA was preferrable to investing everything in the first month.
Imagine a scenario where the market drops consistently for 12 months. A monthly DCA strategy would buy the investment at a lower price each month, whereas the full investment up front would have locked you into the top price. You can also imagine the opposite scenario where the market consistently increased for 12 months. Then you would have preferred to invest everything in the first month, since that was the lowest price of the year.
Benefits and Drawbacks
The primary benefit is to reduce the risk of trying to time the market. Instead of investing all your money at once, slowly investing over time can help smooth out the fluctuations in the market in the short term. For investors who have money and look to invest in something with a good return, the DCA strategy can help reduce the tendency to purchase at the top of a market. Investing over time is also a great strategy as you receive the funds, as in the case of 401k contributions from your income. Many are saving every month and do not have access to all their contributions in the first month. Regardless, they can benefit from the strategy by buying investments both when markets are up and when they are down.
One notable drawback to the DCA strategy is the opportunity cost, specifically the potential return you would have received had you not done the strategy. Especially for larger sums you may receive, waiting months or years to fully invest the funds could result in missed returns. It’s important to calculate the potential reward of investing everything immediately. For those saving for goals years or decades away in the future, a DCA strategy could have such a minimal benefit that it may not be worth it.
To determine whether the benefits outweigh the drawbacks, you need to understand the goals and objectives for your investments. Investor emotions can, at times, disrupt their own financial goals. Many times, selling in a down market is not the best move, and the DCA strategy can help combat those emotions. Instead, this strategy would specifically buy in down markets to lower your average price. When the goal is to buy low and sell high, it gives investors a different perspective on when markets and accounts are declining.
Takeaways
Many investing strategies could help someone reach their financial goals. The DCA strategy is one specific strategy that can help smooth the sometimes rocky ride of investments. Especially investing in the stock market, splitting up your purchases over time can help dampen the risk that you are investing at the “wrong time”. As with any investing strategy, it is important to seek wise counsel and build a plan around your savings. If done successfully, the DCA strategy (paired with many other strategies) can be a great resource to help you increase your wealth.
TC Falkner 