Dollar-cost averaging is one of the most popular strategies for building investment portfolios. The term refers to investing equal dollar amounts in assets like stocks, bonds, and currency markets, at regular timed intervals.
By dollar-cost averaging, you take advantage of swings in asset pricing caused by the natural movement of the markets. However, rather than trying the futile task of timing the markets, you buy the asset at predetermined price points.
There are both pros and cons to this investment strategy, and you might be wondering if it has any benefit over going “all-in” with your investment using a lump sum strategy instead.
In this article, we’ll look at how dollar-cost averaging works, and how it compares to investing with a lump sum.
Dollar-Cost Averaging Explained
- 1 Dollar-Cost Averaging Explained
- 2 How to Swing the Odds in Your Favor?
- 3 Lump-Sum Investing and the Issues with Timing the Market
- 4 Building a Stock Position Using Dollar-cost Averaging
- 5 You Might Already Be Dollar-cost Averaging
- 6 Which is the Better Investment Strategy?
- 7 Why Is Lump-Sum Investing More Successful than Dollar-Cost Averaging?
- 8 The Key Takeaway
- 9 Wrapping Up – Which Investment Strategy Is Right for You?
This strategy refers to investing money at specific price points over equal time intervals. It’s very different from investing a lump sum in the market and requires insight into the asset class in which you’re investing.
For example, you might want to invest in Facebook stock or Tesla. If you have $10,000 to invest in the stock, then you could take a lump sum and plow it into the market at the next price opportunity.
With a dollar-cost average strategy, you might take the position of adding $2,000 to your stock position over 5-months, until you invest the entire $10,000 amount. Using this method, you steadily build your position over 5-months, instead of assuming total risk in the first lump sum allocation.
Some investors use dollar-cost averaging to build a stock position quickly instead. For instance, you could invest $2,500 into the same stock every week, building a $10,000 position in less than a month.
Conversely, dollar-cost averaging can also build positions using a long-term strategy as well. You might only invest $2,500 every 6-months, taking 2-years to build your position.
As you can see, dollar-cost averaging is not a complex investment strategy, and there are a variety of methods you can use to implement it in your investments to suit your investment style or investment goals.
How to Swing the Odds in Your Favor?
One of the best reasons to utilize a dollar-cost average strategy in your investments is to secure a mathematically-favorable average cost basis for your investments. If that sounds like a mouthful, then review the following example.
If you want to invest $10,000 into a specific stock you researched and identified as a potentially good investment; then you might want to use the example of investing $2,000 in the stock at the beginning of each month to steadily build your position.
For our example, we’ll say that the price of the stock is $50, $40, $20, $40, and $50 for each of your 5-monthly investments. With this price movement, we can see that the price of the stock moved up and down during the five months, ending right back where it started, at $50.
Traders refer to this price action as “volatility.” When markets are volatile, the price action of the stock changes day to day or week to week, depending on the fundamentals of the company, breaking news regarding new developments in the company, and overall market dynamics.
Using the dollar-cost averaging example mentioned above, you make a total of 5-stock purchases, at the prices of $40, $50, $40, $20, $40, and $50. You add them up to a total of 240 and then divide by 5, giving you a dollar-cost average of $37.71 per share. Therefore, the average price you pay per share is lower than 4 of the 5-price points.
In this scenario, your dollar-cost averaging paid off for your investment strategy, and you paid less than the average share piece over the five months of your investment. Your final average price, known as your “cost basis,” is $35.71. To get your entry lower than this, you would have had to invest a lump sum when the price was around the $20-mark to do better.
Lump-Sum Investing and the Issues with Timing the Market
However, your chances of timing the market with your lump sum investment might not prove to be the right strategy. You could end up buying into the market with your lump sum when the price peaks at $50. As a result, you miss out on the potential gains you got from the dollar-cost average example.
Predicting the future is impossible, regardless of what your psychic tells you during your reading. There are so many economic variables responsible for moving the market, that no savvy investor can accurately predict the price movement of asset classes.
Some investors have plenty of experience in watching and participating in the markets. As a result, they have a seasoned approach to investing, and they typically win more than they lose.
Therefore, these investors often offer their advice on TV stations and in financial publications. However, if you sit down and talk to them about their investment decisions, you’ll quickly find out that they are doing nothing more than making “educated guesses” for the movement of the market.
There is no way to accurately pinpoint turns in the market, no matter what anyone tells you.
Building a Stock Position Using Dollar-cost Averaging
Using this strategy to build a position in any asset class is relatively straightforward and simple to master. Follow this step-by-step process of using dollar-cost averaging in your investments.
- First, decide on how much you want to invest in the stock.
- Next, decide when you want to make your investment; daily, weekly, monthly, bi-annually, or annually.
- Finally, divide the dollar amount by the period to get the amount you need to invest at each stage.
For instance, if you have $10,000, you could invest it in portions of $1,000 at the beginning of every month for the next 10-months. Or you could invest $2,500 at the beginning of each week for a total investment period of 1-month.
You’ll need to consider the fees and commissions involved with managing your investment strategy, as well. If you go ahead and put a lump sum into your brokerage account in one transaction, then you’ll have fewer fees and commissions than if you dollar-cost average throughout 10-months.
However, there are also pros to investing over a longer period, at more entry points, as well. As we mentioned, volatility is a crucial concern for any investor. While investing with a lump sum might reduce your commissions, it also increases the risk involved with the trade.
What if you miss-time the market, and get in at the peak? The stock could tank 20% over the month after your investment, and the price will have to recover 20% just to reach your starting point again. This kind of loss can ruin many investors’ portfolios and gives them uncertainty in their current investment strategy.
By dollar-cost averaging, you’re less concerned with finding the best entry point for your stock purchase. Instead, you’re relying more on the overall trend in the stock. In other words, is the stock moving up or down?
If the stock is trending up, then there’s a good chance that you’ll still receive a profit on your investments over the year, and some of your entry points will be better than others, resulting in better performance of your stock portfolio.
You Might Already Be Dollar-cost Averaging
Many Americans make use of IRA and 401(k) accounts when saving for their retirement. These vehicles collect money from numerous investors and place it into a pooled fund. A fund manager then allocates the money to different investments, such as stocks, bonds, and REITs.
Let’s say you’re an employee that’s earning $60,000 per year. From your earnings, you send 5% of your monthly paycheck to your 401(k), and your employer matches your contribution. As a result of your monthly contributions, your 401(k) grows by $6,000 every year.
However, it’s important to note that the fund manager doesn’t allocate your contributions annually, they do so on a month-to-month basis as more money comes into your account. Therefore, your fund manager is effectively using a dollar-cost average strategy already.
Therefore, your fund manager is buying some assets when the price is high and might add to the position when the price drops or rises as your money deposits into your 401(k) account over the year.
You can use this dollar-cost average strategy when handling your investments, as well. By putting money into your brokerage account and allocating it once a month or once a week, you’re effectively following the same strategy used by professional fund managers.
Using dollar-cost averaging, you’re not trying to time the market, but instead investing in the overall trend. As a result, you get to take advantage of some price dips, hoping that your investment strategy pays off at the end of the year.
Which is the Better Investment Strategy?
This question is a classic debate between investment advisors. There are convincing arguments about the efficacy of each strategy, but which one yields superior results?
According to research from Vanguard, lump-sum investing offers investors the best returns. That might surprise you, considering we’re focusing so heavily on dollar-cost averaging in this article. In its study, Vanguard compared data from historical investment strategies run by investors in the U.S, U.K, and Australian markets.
With a 405 Bonds and 60% stock allocation to the portfolio, the study went about comparing lump-sum investments with a monthly dollar-cost averaging strategy, over the same period.
The results show, that over 12 months in U.S markets, the lump sum strategy outperformed dollar-cost averaging strategy 68% of the time, and with an average margin of 2.39%. The research shows that lump-sum investing is a better strategy over long periods.
In 6-month investment periods, the lump-sum strategy outperforms the dollar-cost averaging strategy 64% of the time. When stretched to 36 months, the lump sum strategy was the better option in 92% of cases.
Why Is Lump-Sum Investing More Successful than Dollar-Cost Averaging?
The answer to this question has two answers. First, over the last 10-years, stocks have trended upwards. Therefore, in theory, shares will cost more next year than they do this year. The second component of the answer is whats known as “cash drag.”
Cash drag is the result of leaving your money on the sidelines, doing nothing for you, as it waits for its allocation per your investment plan.
The Key Takeaway
- If you have a lump-sum you’re looking to invest; then it’s a better move to invest it all right away in one move, rather than dollar-cost averaging your way into a position.
- However, some people might not have the financial resources to invest a lump-sum in the market right away. Therefore, dollar-cost averaging presents an attractive option for investors that want to grow their portfolio over time steadily.
Wrapping Up – Which Investment Strategy Is Right for You?
- Invest a lump sum, which is the ideal option for investors that have the funds on hand and don’t want to suffer any cash drag from their investment strategy.
- You can dollar-cost average into your position, investing equal money amounts at predetermined intervals.
- You could also buy an equal amount of shares with your dollar-cost averaging strategy, or you could buy a set dollar amount of shares.
When considering your investment strategy, it’s best to get the advice of a professional.
Arrange a consultation with your financial advisor to discuss your options. Having an investment plan is an essential part of any investment strategy. Without a plan, you have no direction, and you’ll end up taking on a risk that you could avoid.
While risk is an integral part of any investment, it pays to manage the risk, rather than to blindly walk into an investment that could eat away at your retirement savings.
The best time to use Dollar-cost averaging is during periods of intense market volatility.
Volatility is currently increasing, and we can expect it to escalate in 2020 as the elections draw near. Using a dollar-cost averaging strategy can provide you with a hedge against market uncertainty.
However, the final choice in your strategy is up to you to make – good luck, and trade accordingly.