Advantages and Disadvantages of Dollar Cost Averaging
When it comes to investing, timing is crucial. Yet, predicting how the market will move nearly impossible. Since we don’t know for sure what tomorrow will bring, the best time to invest is now, rather than sitting on cash and watching inflation impact your savings.
What if you didn’t have to choose one time to invest? What if you could spread your investments, increasing the odds that your investments will experience positive returns?
Rather than investing all-at-once, investors can utilize dollar cost averaging to reduce the impacts of market volatility. Dollar cost averaging provides benefits over traditional investing (stock picking and market timing) that reduce risk, serve a long-term approach and can prevent us from making poor decisions. Most importantly, dollar cost averaging is a fantastic budgeting tool because it allows investment decisions to be automated rather than a conscious decision. Our emotions and impulses can get in the way of deciding when to invest due to the noise associated with day-to-day market movement.
What Is Dollar Cost Averaging?
Dollar cost averaging involves purchasing shares of a fund with a set amount of money over regular intervals. As a result of market activity, sometimes you end up buying at a low point, while other times you end up purchasing at a higher price.
Over the long-term, dollar cost averaging tends to lower the average cost per share since you end up purchasing more shares when prices are lower and less shares when prices are high.
How does dollar cost averaging actually work? Let’s look at an example where we’ll compare a dollar cost average strategy versus a traditional lump-sum investment.
Lump-Sum vs. Dollar Cost Averaging
We will begin by looking at what a one-time, lump-sum investment. Let’s say you have $50,000 that you use to purchase a fund at $50 per share, giving you 1,000 total shares. Now let’s see what $50,000 buys you when purchasing at regular intervals. Let’s spread the $50,000 investment across four purchases, $12,500 per purchase. Since the market is constantly fluctuating, the share price will allow you to buy varying numbers of shares each time you invest.
|Share Price||Number of Shares Purchased|
Even though the average share price across all four investments is $50 per share, you end up with 1,005.84 shares, 5.84 additional shares for the same $1,000 purchase. Nearly six additional shares may not seem like a lot of shares. However, keep in mind this is a long-term investment, and these additional shares add up substantially over 20-30 years. Owning more shares means that you’re able to generate more value in your portfolio as the value of those shares increase over time.
Advantages of Dollar Cost Averaging
In addition to potential higher earnings and lower costs per share, dollar cost averaging provides numerous benefits for investors. These include:
Protecting You from Your Worst Instincts
When investing, sometimes your worst enemy can be your own mind. While we know the market always has its ups and downs, it’s tough to remember this when watching your investments have a particularly unfortunate day. The urge to sell off during a market slump is a natural instinct, but it’s also not prudent investing. This down market should be the time to make purchases while prices are low. Investing consistently and utilizing dollar cost averaging helps protect us from the biases that make irrational decisions.
Providing a Long-Term Approach
Automating your financial journey by utilizing dollar cost averaging helps instill a long-term approach that should ultimately benefit your earnings and provide peace of mind. There will be times when you bought at a higher than ideal price or when your investments appear to be losing value. However, the long-term behavior of the market trends upward over time, with peaks and valleys along the way. Being an informed investor means waiting out the storms until the market eventually recovers. Remember, our goal for you is to help you achieve financial freedom and maintain your desired lifestyle during the years you’re decumulating your assets.
Helping You Avoid Missing Market Moves
It’s rare to perfectly time an asset purchase exactly when the asset begins to heat up. With dollar cost averaging, you are more likely to buy in at the right time since purchases are made at frequent intervals rather than all-at-once. When you get more opportunities to invest, you have a higher chance of meeting your investment goals.
Disadvantages of Dollar Cost Averaging
While a dollar cost averaging is generally an effective tool, it does not guarantee anything. There are certain downsides to the approach and situations where a dollar cost averaging may be less effective, such as:
Making You Late to the Party
Since purchases are automated, you sacrifice some control when you buy, which might lead to missing out when the market heats up. Dollar cost averaging usually delivers superior buying power during a falling market, but it’s less powerful when the market is rising. However, since the market is constantly fluctuating, your investments can eventually pay off once the market cools down.
Not Paying Off During Extended Downturns
Like most investments, dollar cost average is not immune from long downturns. If prices fall all year without a rally, even dollar cost averaging won’t alleviate the pain. However, the data suggests that markets eventually rebound, so you’ll be well positioned when it does.
To maximize the benefits of dollar cost averaging, start investing as early as possible. Whether you’re investing weekly, monthly or quarterly the important thing to do is start. At TCI, one of our investment philosophies is to keep fees low, but as with any investment, pay close attention to the costs associated with your fund purchases. The goal of any wealth management journey is to be financially free upon retirement. TCI is here to help you plan your investments so that your future may be a financially free one by utilizing strategies like dollar cost averaging.