Wars and rumors of war, Inflation, and rumors of high-interest rates. COVID-19 virus death toll and its persistent impact on our economy. Wars, Inflation, and pandemics continue to strike fear in investors' hearts and minds. The ups and downs of the stock and bond markets are very telling. The question that has been asked a lot lately is this, “Is this a good time to invest lumps sums of money or should I use dollar-cost averaging?"
Timing The Market
So, let’s have a conversation. It would be great if we could buy stocks, or other types of investments, when the market is low and sell when the market is high. Unfortunately, efforts to “time the market” often backfire, and investors end up buying and selling at the wrong time. When stocks go down, people often get fearful and sell. Then, when the market goes back up, they might miss out on potential gains. On the flip side, when the stock market goes up, investors might be tempted to rush in. But they could end up buying just as stocks are about to drop. The process of dollar-cost averaging can help take the emotion out of investing. It compels you to continue investing the same (or roughly the same) amount regardless of the market’s fluctuations, potentially helping you avoid the temptation to time the market.
Closer Look: Dollar-Cost Averaging
Dollar-cost averaging is a strategy where you invest your money in equal portions, at regular intervals, regardless of which direction the market or a particular investment is going. In other words, your purchases occur regardless of the changes in price for the stock or other investment, potentially helping reduce the impact of volatility on the overall purchase. This can serve as a risk management trading strategy if you end up buying more when the price is relatively lower and buying less when the price is relatively higher.
Here's a working example. Suppose you have $5,000 to invest and have identified a stock you would like to purchase. However, you are unsure when and at what price you would like to buy the stock. Using a dollar-cost averaging approach, you might decide to invest $1,000 a month for 5 consecutive months. In an ideal scenario, the stock price will decline after your initial trade so that you are dollar-cost-averaging in at lower prices (i.e., a lower average stock price compared with the initial price).
The table below to see how this strategy might play out using varying stock prices.
After using all of your intended $5,000 for this trade, you purchased 253.4 shares for a dollar-cost average stock price of $19.73. This compares favorably with buying 250 shares if you had used all of the $5,000 to make a lump sum investment at the original $20 per share purchase price.
Please note that the example excludes trading costs and assumes fractional shares enabled. Also, if you are investing in a stock or other asset because you like its long-term prospects, and have decided on an amount to invest, then making a lump-sum investment when you make that decision may be the right strategy.
DCA May Be Working For You Already…
It's worth noting that you may already be utilizing a dollar-cost averaging strategy. If you have a 401(k) or another type of defined contribution investment plan such as a TSP, TDA, or TSA, your contributions are allocated to one or more investment options on a regular, fixed schedule, regardless of what the market is doing.
As a risk management strategy, dollar-cost averaging attempts to help address the risk of using all your intended funds for a particular investment at a point in time when the price may be relatively high or volatile. Market timing is exceedingly difficult, even for professional investors.
A key advantage of using a strategy like dollar-cost averaging is that it can help mitigate the effects of investor psychology, as it relates to trying to time the market.
With a dollar-cost averaging approach, you may avoid making a counter-productive decision due to emotions like fear or greed. This is when you buy more when prices are going up or panic about selling when prices are going down).
Dollar-cost averaging might be appropriate if you think there is a possibility that your investment opportunity may decline over the short term (to some extent), but you believe it will rise over the longer term.
The drawbacks of dollar-cost averaging should be apparent.
If the price of the investment rises throughout executing a dollar-cost averaging approach, you will end up buying fewer shares than had you made a lump sum investment at the outset. Suppose the dollar-cost average was $21 using our example above. By the end of making your fixed investments at regular intervals, you would have ended up with 238 shares (compared with 250 shares if you had made a lump sum investment on January 15).
Another possible drawback would be your funds waiting to be invested. Typically held in a money market, savings or checking earning very low rates of return until invested. This does not apply to a scenario like your contributions to a 401(k), because you are making your contributions to those accounts as you earn funds (and not with funds that you already have and are waiting to deploy).
Dollar-cost averaging can help you manage risk.
Dollar-Cost Averaging may help mitigate some of your risks, it might also mean you could forgo some return potential.
This strategy involves making regular investments with the same or similar amount of money each time.
It does not prevent losses, and it may lead to forgoing some return potential.
You should also be aware of any trading fees you might incur in your trading account making multiple transactions.
‘Pros and Cons Of Dollar-Cost Averaging.’ Fidelity Investments at Fidelity.com
‘Three Things To Know About Dollar-Cost Averaging.’ FINRA at FINRA.org