Dollar cost averaging is a simple yet effective strategy for dealing with stock market volatility. Rather than trying to time the market with a large lump sum investment, it invests smaller amounts at regular intervals.
Sometimes dollar cost averaging works better than lump sum investing. Sometimes lump-sum investing works better.
Find out when each option works best.
What is the dollar cost mean?
Dollar cost averaging involves periodically investing a series of equal amounts at regular intervals.
Since the amount invested is constant, this investment strategy buys fewer shares when share prices are high and more shares when prices are low. It implicitly implements the advice to buy low, sell high.
Dollar cost averaging addresses the volatility of stock prices by averaging the purchase price over time. As such, it reduces the risk of a bear market or correction, where the stock price can fall quickly after making a flat-rate investment.
As a formula strategy, dollar cost averaging avoids emotional decision making such as panic selling, fear, fear of missing out and greed that come with the ups and downs of the stock market. It also helps investors to be less emotional about downturns in the stock market as they invest smaller amounts at a time.
Dollar cost averaging is commonly used with 401(k) retirement plans, where a fixed percentage or amount of the employee’s salary is contributed to the retirement plan after each paycheck. You invest the money as you earn it. Automatic investment plans for 529 college savings plans work in a similar way.
Dollar cost averaging is best used with index funds and ETFs, as opposed to individual stocks, because a diversified investment will be less volatile.
Sometimes dollar cost averaging is just timing the market
When people have a lump sum to invest, they often insist on investing it in several equal monthly installments because they have heard that dollar cost averaging is a smart way of investing. They want to relax in the targeted asset allocation, instead of jumping in the foot first.
Sometimes they fear that the market will collapse right after they make a large lump sum investment, even if they have already invested a lot more money.
But by deferring the entire investment of the lump sum, they are investing the money on a different asset allocation than that dictated by their risk tolerance. The portion that has not yet been invested is effectively invested in cash, which changes the mix of investments.
If the cash-cash argument is based on expectations of short-term investment returns, then you may need to rethink the asset allocation for the entire portfolio, not just the new contributions.
This use of dollar cost averaging, also known as time diversification, is actually a form of market timing.
Timing the market is not an effective investment strategy. On average, there are 50/50 chances of the stock market going up or down on any given day. You cannot consistently accurately predict peaks and troughs. Since stock market movements are impossible to predict accurately, investors waiting to invest could be missing out on investment returns, not just investment losses. Investors trying to time the market will miss the days with the best return on their investment, reducing their long-term profits. Time in market is more important than timing of the market.
Averaging the dollar cost is a good strategy for investing a periodic payment, such as contributions to retirement plans. It buys more shares when prices are low and fewer shares when prices are high.
But through dollar cost, the full amount is always invested as soon as the money is available. It does not delay the timing of an investment. It is not a suitable investment strategy for a lump sum as opposed to a periodic payment.
It is more important to diversify investments within asset classes than to diversify them over time. In the long run, spreading a lump sum investment over a few months won’t make much of a difference in the long-term return on the investment.
When does dollar cost averaging work well?
Dollar cost averaging works best when the stock market is volatile and you are investing over a longer period of time.
When the stock market is trending upward, lump sum investing works better. By averaging the dollar cost, you are missing out on the potential gains that you could make if you had invested the full amount immediately. Deferring the investment of a lump sum means that some of the money is in cash rather than fully invested.
For example, if you had invested a lump sum in the S&P 500 on the first trading day in January 2021, you would have made a 29% return on your investment by the end of the year. If you split the money into equal monthly investments on the first trading day of each month, you would have earned only a 22% return on investment at the end of the year. On the other hand, 2020 was a much more volatile year, with flat-rate investing yielding returns of 15%, compared to 27% for the dollar cost average due to the bear market that occurred in February and March of 2020.
Even when investing during a volatile stock market, the advantage of the dollar cost average versus a lump sum investment is sensitive to the timing of the start of the investment. If you start investing right before a stock market correction, the dollar cost averaging will outperform a lump sum. But if you start investing immediately after a stock market correction, the dollar cost average will underperform a lump sum.
Dollar cost averaging also works well in a bear market, where the stock market is on a downward trend as it reduces losses compared to a lump sum investment before a market decline.
This post When the dollar cost averaging works and when it doesn’t?
was original published at “https://thecollegeinvestor.com/39626/when-dollar-cost-averaging-works-and-when-it-doesnt/”
