If you are an investor looking for a strategy that cuts down on your investment risk, you might want to consider a dollar-cost averaging strategy. Of course, while this approach helps you better manage risk, you are also less likely to experience outsized returns.
The term dollar-cost averaging refers to the practice of investing a consistent dollar amount in the same investment over a period of time. For instance, you might be interested in buying XYZ stock but don’t want to take the risk of putting in your money all at once.
You could instead invest a steady amount, say $300, every month. If the stock trades at $10 one month, you will buy 30 shares. If it later goes up to $12, you will end up with 25 shares that month. And if the price falls to $8 another month, you will accumulate 37 shares. If you invest in a 401(k) plan, this is actually your approach. If you stick to your asset allocation for a longer term, you are putting in a constant dollar amount every month into a specific allocation of investments.
There are both pros and cons to dollar-cost averaging that can help an investor determine if it is the right investment strategy for them.
- Dollar-cost averaging refers to the practice of investing a consistent dollar amount in the same investment over a period of time.
- The method of dollar-cost averaging reduces investment risk but is also less likely to result in outsized returns.
- The pros of dollar-cost averaging include the reduction of the emotional component of investing and avoiding bad timings of purchases.
- The cons of dollar-cost averaging include missing out on higher returns over the long term and not being a solution to all other investing risks.
Reduces Emotional Component
One advantage to dollar-cost averaging is that by investing mechanically, you will take the emotional component out of your decision-making. You will continue on a preset course of buying a certain dollar amount of your preferred investment irrespective of how wildly the price swings. This way, you will not bail out of your investment when the price goes down in a wild swing, but rather see it as an opportunity to acquire more shares at a lower cost.
Avoids Bad Timing
If you invest your money all at once in a particular investment, there is the risk that you will invest just before a big market downturn. Imagine you had jumped into an investment just before the market downturn that began in 2007. You would have ended up losing more money than if you had invested only some of your money before the downturn.
It is almost always impossible to determine a market bottom, which is why dollar-cost averaging can help smooth out market timings.
Of course, the other side of this coin is that you might also miss out on investing at just the right time before the market starts trending upward in a bull market.
Market Rises Over Time
A disadvantage of dollar-cost averaging is that the market tends to go up over time. This means that if you invest a lump sum earlier, it is likely to do better than smaller amounts invested over a period of time. The lump sum will provide a better return over the long run as a result of the market’s rising tendency.
Not a Substitute for Identifying Good Investments
Dollar-cost averaging is not a solution for all investment risks, however. You will have to take on the task of identifying good investments and do your research even if you opt for a passive dollar-cost averaging approach. If the investment you identify turns out to be a bad pick, you will only be investing steadily into a losing investment.
Also, by adopting a passive approach, you will not be responding to the changing environment. As the investment environment changes, you might get new information about an investment that might want to make you rethink your approach.
For instance, if you hear that XYZ company is making an acquisition that will add to its earnings, you might want to increase your exposure to the company. However, a dollar-cost averaging approach does not allow for that sort of dynamic portfolio management.
The Bottom Line
If you are a less experienced investor and want to follow a preset approach so that you are not exposed to wild market swings, dollar-cost averaging could be a good approach. On the other hand, if you are experienced, you might be able to get better returns by active strategizing rather than going for dollar-cost averaging.