It's natural for individual investors to get emotionally invested in the stock market, leading to an attempt to time the market and get the best price for the best return. We all know that timing the market is a losing game. That's why investors turn to what's called dollar cost averaging.
What is dollar cost averaging? Does it actually work? And, how does one implement a dollar cost averaging strategy to their portfolio?
Dollar Cost Averaging Explained
Let's pretend you have a lump sum amount of money, say $100,000. You've determined the companies you wish to invest the money in. The question now becomes “when do I pull the trigger and buy in?”
On the one hand, if you purchase right now, what if the stock price drops dramatically tomorrow, and your whole portfolio takes a hit? Or, if you purchase now, what if the company accelerates and provides double digit market returns? The truth is, you will never know, and at this point you're trying to time the market…again.
But what if you were to take that $100,000 and invest $10,000 per month for 10 months into your target companies and funds? This would then spread out your purchase prices among different price points with some months being great prices to buy in and other months to be a bit more expensive (again, in the long run we don't know what cheap or expensive is…thus we're purchasing at different time frames to lower our average purchase price and volatility). This is called dollar cost averaging.
Statistically, when spreading out your transactions among multiple regular intervals to buy, you are getting in at different prices which ultimately reduces your portfolio volatility. The end result is the average price at which you bought in ends up being lower overall than making one purchase with the $100,000 up front.
Consider the following table and prices at which you may have bought your investments spread across 10 months time:
|Average Price =||$105.30|
By dollar cost averaging, your average purchase price is $105.30. But, what if you had tried to time the market and predict the lowest price? Or, what if you would have decided to invest the whole $100,000 in month 3?
Dollar Cost Averaging Definition
In short, dollar cost averaging is an investment strategy where you spread your investment purchases across multiple time frames and purchase prices in order to lower your overall volatility and average investing purchase price. An example is investing a dollar amount every week, biweekly, monthly or quarterly regardless of the purchase price or market economics.
The Benefits of Dollar Cost Averaging
Should you implement dollar cost averaging in your portfolio? Here are some benefits of doing so:
- It removes emotion: Dollar cost averaging takes your emotions out of the game. You don't have to worry about whether you're getting a good price or not, because the average will likely be a better price than what the rest of the market paid.
- Better purchase price: As shown in the table above, your average purchase price is likely to be much better than trying to time your purchases.
- Better potential returns: With a better purchase price comes a better investment return because you bought your security at a lower average price.
- Investing on autopilot: Building a habit of investing regularly is a must for long term successful investors. With dollar cost averaging, you're putting your investing on autopilot.
- Lower portfolio volatility: Having bought in at multiple price points levels out your portfolio volatility. If price goes down, your whole portfolio doesn't get affected at once, just the portions you purchased at higher prices see the biggest hits.
Easy Ways To Start Dollar Cost Averaging
If you have an investment account already, all you need to do is set up automatic deposits to your account and have them automatically invested in the desired securities. You'll find that some investment accounts don't always allow you to invest on autopilot, they might just let you make cash transfers on autopilot.
Here are a few great options for setting up dollar cost averaging on complete autopilot:
After creating your own portfolio of companies, each deposit you make is invested automatically and in the pre-selected proportions to each company. And its free to start!
By linking your bank account to Acorns, they will round up every purchase you make to the next dollar and invest the spare change into a customized investment portfolio for you. When setting up your account through our link here you get $5 just for signing up.
Peer to peer lending as an investment can be done with prosper in as little as $25 increments. Set up auto invest to start contributing $25 or more to different loans.
After answering a few questions about your investment objectives, Betterment will design a customized portfolio for you and automatically invest your money for you.