Do you know what is dollar-cost averaging? Not everyone is aware of this concept and doesn’t know why does it even matter! On the other hand, the complexity of the finance markets creates a playing field where there are nearly limitless possibilities for trying to turn some money into more money. The biggest players in the industry have at their command ground-breaking algorithms for buying and selling securities that were discovered by some of the most brilliant minds on the planet.
Average investors, however, don’t have such tools at hand. However, the smaller sums we’re working with allow us more flexibility while still providing opportunities to generate returns. One such strategy is called dollar-cost averaging. Let’s help explain what it is; so you can understand how to implement it as well as whether it’s the right strategy for your portfolio.
Table of Contents
What is Dollar-Cost Averaging?
Dollar-cost averaging is the practice of buying securities at regular intervals to untangle the volatility in your portfolio. This is a practice that absolutely anyone can use because of its simplicity. There are a few drawbacks, but the benefits of dollar-cost averaging may prove to outweigh the downsides.
How Does Dollar Cost Averaging Work?
There are two requirements in order to effectively dollar-cost average:
Buy at regular intervals.
Buy the same amount at those pre-set intervals.
Seems simple, right? Dollar-cost averaging is one of the simplest investing strategies to implement. Moreover, for average investors, it can be the most effective. The markets are always going up and down, and nearly everyone will tell you that it’s impossible to know precisely when the market will turn. This is where dollar-cost averaging can benefit you.
If you are constantly buying into the market regardless of where assets are priced, you will find that any buy-high, sell-low scenarios average out.
Put another way, let’s say you buy shares right before the market drops from under you. When you go to buy again at your scheduled interval, you are buying at a lower point. After the second purchase at the bottom, the price rises to halfway between the two times you bought shares.
Assuming you bought the same amount at both points, you would see a net-zero loss in your portfolio after the price recovers only halfway. If you had bought it all at the first point before the price dropped, you would have needed to wait for the price to return to your original price to see any profit, whereas dollar-cost averaging allowed you to lower the price where you would be breakeven.
Is Dollar-Cost Averaging a Good Strategy?
Some events may cause drops in the market, such as the bear market we experienced in 2020. However, they are short-lived, and you can never know when the right time is to sell out or buy back in. Dollar-cost averaging is a great way to avoid analyzing the market and stress out over buying low and selling high every time.
As we saw in the last section, you also have the benefit of improving your breakeven regardless of what prices are doing. If the market falls over a long period and you continue buying at your regular intervals, you keep lowering the breakeven of your investments. When price turns around, which it usually does in most cases, you will see profit far sooner than if you had put it all in at once.
How Do I Dollar Cost Average?
The first step to getting started with dollar-cost averaging is making sure you set a figure each month or twice a month that fits your budget. If you haven’t looked at your budget recently, you can get started with any number of online budgeting tools; such as “Mint” or “Honeydue” (which is great for couples). After you set the figure that makes sense, you need to find a brokerage that makes automatic deposits as easy as possible.
Many brokerages and investment firms are making dollar-cost averaging simpler by allowing automatic deposits. Even mobile apps like Acorns make this process more accessible, and they even allow for versatile investment options. Once your investments are on autopilot, you are all set on your dollar-cost averaging journey.
Assumptions When Dollar Cost Averaging
Dollar-cost averaging requires us to make several assumptions. We’ve already discussed the last two, but it helps to have all of the information in one place. Therefore, you know what makes this strategy work over the long term.
- Reasonable risk: If you’re buying risky assets or stocks whose companies have a higher chance of failure, dollar-cost averaging may not payout long term.
- Markets generally go up over the long term: The goal of dollar-cost averaging is profit over a number of decades. History has shown that most developed economies with stable financial markets see growth over the long term, with some years here and there with losses. Dollar-cost averaging will only work if markets continue to go up over the long term generally.
- Buying the same quantity at the same interval: As we spoke of earlier, the best averaging can be seen when you take out as many variables as you can. By keeping the amount you purchase and the intervals at which you are buying constant, you have the highest likelihood of improving your profit potential.
Benefits That Will Fill-Up Your Pockets
As we’ve discussed, there are several benefits of implementing dollar-cost averaging; especially for regular investors trying to build a retirement account.
- Less Decision Making: At the end of the day, you probably have other things going on in your life. You’ve got your day job, maybe kids to take care of, and hobbies that don’t involve researching the financial markets. It’s an averaging that allows you to use a proven strategy without having to add to your busy schedule.
- Avoid Poor Market Timing: There are no doubt times when you thought to yourself, “I need to sell now – markets are at all-time highs, and I might save money by selling into cash and waiting for the correction.” Then, the market continues to rally for months before a brief correction comes; and you’ve left money on the table. You can’t accurately and consistently time the market. Also, dollar-cost averaging is a great way to avoid buying or selling at the wrong times.
- Improved Break-even in Falling Markets: As we discussed earlier, even if you buy right before the market falls off a cliff, buying after the fall using dollar-cost averaging strategies allows you to bring your breakeven price down, meaning you can profit sooner than had you bought all of it before the market dropped.
- Less Worry About Bear Markets: The media is always talking about the next correction, recession, or bear market, which drives people to make poor investing decisions. When you dollar-cost average, you don’t have to worry about the markets falling. You are in this for the long term, and the brief losses will turn to profits; if you stick to the plan.
Drawbacks You Must Know
If you have a stock in mind that you know for sure can only go up, then by all means – put as much money as you can into that stock as you can now! The biggest drawback of such an averaging is that profits are finite in rising markets.
However, always remember that assuming you’re investing for a long-term goal like retirement or college tuition for children, you aren’t trying to make as much money as possible as quickly as possible. Your goal is to get returns that drive growth and reduce risk in the investments.
Another issue with this type of averaging is that if your brokerage charges you on each transaction, your costs may be a bit higher. The good news on this front is that most brokerages are moving toward setting less in transaction fees; they are doing so to encourage investors to move toward consistent deposits rather than lump-sum deposits.
What’s Next: Dollar Cost Averaging
Such an averaging is an excellent way for investors to smooth out the volatility in an investment portfolio; considering a long-term investment. Not only does it reduce risk and improve the investment journey, but it also is an exceedingly simple strategy to implement. While there are drawbacks involving reduced profits in rising markets, markets are not always rising in the short term;so the long-term benefits make dollar-cost averaging that much better.
We hope you got all your answers that relate to what is dollar-cost averaging!
