When it comes to planning for your future, most people generally want a stable, less risky and predictable return. Dollar Cost Averaging may be the perfect approach in these cases. It allows investors to continue to buy and invest in the markets will limiting risk and it also tends to have the best long term, predictable results. The approach involves making consistent contributions over time.
Unfortunately the safest options for saving or investing, things like a savings account or bonds, yield the lowest returns. More substantial returns require wading into the world of investing, which necessarily comes with more risk. Dollar Cost Averaging is a financial literacy tool to help you reduce/control that risk (as much as possible). It puts investing on auto-pilot and it helps reduce the emotional ups and downs of investing in the market.
That risk of losing big often stops people short of attempting to invest. There are relatively safe investment strategies, however. While nothing involving the market is 100% risk-free, various “low and slow” strategies (like Dollar Cost Average – DCU) can reduce risk to an acceptable level given the expected improvement in returns. It is very effective.
One of those more effective strategies is called “dollar cost averaging.” It’s a particularly popular option among those who have only a small budget for investment each month, because it’s centered around reducing risk by making small but consistent contributions over time. However Dollar Cost Averaging is not just limited to small dollar amounts – wealthy investors can follow it, and even people with a one time “windfall” like an inheritance. DCU is just about making consistent contributions, whether the market(s) go up or down, the dollar amount invested needs to be consistent.
How Does Dollar Cost Averaging Work?
Here are the broad strokes of how dollar cost averaging works:
- You pick something to invest in that has proven to be relatively stable over time. Over even us the approach for a higher risk investment.
- You make small, regular contributions of an equal amount to this investment vehicle. Or, if you have more to invest, then you can make bigger dollar amount of regular contributions over time.
- Since you are purchasing a fixed dollar amount on a consistent basis, you buy fewer shares when it is expensive and more when it is cheaper. Over time, the average cost of each share you purchase may be lower than it would be with bigger “lump sum” purchases at varying intervals.
- This also offer insulation against a big potential loss caused by a sudden drop just after moving a bunch of money into the investment.
- Dollar Cost Averaging is done on “auto-pilot”. This tends to take the emotions out of investing.
Dollar cost averaging is particularly effective in markets that are temporarily contracting, such as when happens during a financial crisis or when events like the coronavirus disrupt world economies. The shares purchased during the contraction would naturally be at a price much lower than average, blunting the overall total expense as they gradually return to a more normal price over some period of months or years.
Of course, you would want an investment that is not expected to skyrocket once the temporary contraction is over; rather, one that is temporarily below average and is expected to eventually return to its natural average rather than booming before you finish your investment cycle.
How Well Does Dollar Cost Averaging Work?
At this point, it is important to note that dollar cost averaging is not a universally recommended strategy by all financial advisors. Some experienced investors and economists swear by the DCU financial literacy approach, while others disavow it.
The debate is not really over how safe and secure it is, however. Or there is no debate over that it does take the emotions out of it. The debate is more about how good the returns are as compared to more traditional lump sum investment strategies.
It’s true that lump sum investing may bring better returns over time; there are a number of studies that show this to be the case. However, dollar cost averaging is meant for a specific set of circumstances. The professional trader who has lots of time, money and market knowledge might do better with another strategy. Dollar cost averaging is a simple and very manageable strategy for everyday people who only have a small amount to contribute each month or who do not follow the markets on a daily basis. It is great for those who do not want to have to worry about moving money around periodically or dealing with complications like financial advisors.
Dollar Cost Averaging when Financial Crisis Occurs
A number of financial experts have expressed the idea that dollar cost averaging is a particularly good strategy for riding out the market contraction, whether from the 2008-2010 great recession to the current crisis that the coronavirus pandemic is causing. Or during any financial crisis. This theory makes sense on several different levels.
The way that most professional investors make money in a “bear” market such as this one is to short; that is, essentially to bet against the performance of companies that are hurt by the current market conditions. Shorting stocks or any investment is an inherently risky strategy under normal conditions, however. It’s even worse under unprecedented economic conditions. Governments tend to take a dim view of it at all times, but especially during a global crisis. There is always a risk of temporary bans on short selling when things get too rough, and one can sometimes even wander into criminal territory. It is also very risky with tremendous downside. At the very least, it’s ethically questionable and not something a lot of people want to admit to doing when the economy is struggling.
Dollar cost averaging allows you to employ an expected long-term profitable strategy while making a more positive contribution to the market. It doesn’t offer the immediate large returns, but also cuts the risk of the immediate huge losses. If your concern is retirement planning or funds for the future, it’s a much wiser choice. Or if your concern is you want to sleep at night and not be as worried about stock markets or other investments, Dollar Cost Averaging can help there too.
Best Investments for Dollar Cost Averaging
While dollar cost averaging is a potent hedge against long-term risk, it does not protect you from one important issue: picking the right investment! As alluded to earlier, you ideally want to pick something that is at a low ebb right now but is fully expected to recover at some point. A cheap stock that just keeps going down and eventually goes out of business doesn’t help you at all. Therefore buying any one stock (or even a small number) using DCU tends to be more risky.
This is definitely an area where you will want to do research on your own and/or seek the advice of experienced financial professionals. However, a good starting point is to learn about naturally diversified and stable investment vehicles like mutual funds, S&P 500 indexes and exchange-traded funds (ETFs). These investment vehicles blend together a mix of stable stocks to ensure low risk and fairly predictable returns over time. Given the current circumstances, it is more important than ever to review the contents of these funds to make sure they are buying into companies positioned to ride out the global economic slowdown and eventually recover.
Mutual funds as well as ETFs offer another particularly big advantage – low fees. Most funds have you pay only 0.2% to 1% of your total investment each year. Certain types, such as no-load mutual funds, do not have any fees for buying them using dollar cost averaging. Compare this to a direct investment in stock, where their is more risk than a broad sector investment like S&P 500 funds. For a smaller investor, the emotional risk of selling at the wrong time can really eat into your expected earnings over time.
Getting Started With Dollar Cost Averaging
A dollar cost averaging investment plan is usually most beneficial when it runs for at least one year before reassessing or changing the program; however, you can use it on one investment for as long as it makes sense. The general idea is to keep contributing during a “bear” period as well as during a “good” market as well. Over time your cost basis (whether for stock, bond, or something else) will average out, hopefully at a lower dollar amount. It can be used for almost any investment type – discount brokerages, ETF, S&P index funds, mutual funds, and anything. It is possible to start a program using whatever investment type or account you have.
At some future point, it may be possible to cash out of your stock or other investment at some point once it moves into a “bull” period. But that is in a perfect world, and that is not the main point of DCU. As with any type of investing, due diligence is important and required. But there are much lower barriers of entry for the smaller investor with this Dollar Cost Averaging method, as well as a considerably lower level of risk than trying to time the market!
By Jon McNamara