Dollar-cost averaging is an investment technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high. Dollar cost averaging thus lowers the average share cost over time, increasing the opportunity to profit. But dollar cost averaging technique does not guarantee that an investor won’t lose money on investments but it is meant to allow investment over time instead of investment as a lump sum. For some investors it proves to be good strategy and for some a bad strategy specially when it comes to lump sum investment.
Dollar cost averaging is smart investment strategy to many
As said above Dollar cost averaging is considered a smart investment strategy as you can protect yourself against market fluctuations and downside risk in the market. By buying a fixed dollar amount on a regular schedule, your focus is on accumulating assets on a regular basis, instead of trying to time the market.
So you are more relaxed in investing because where the market goes in the short-term is far less important to you, as long as you stick to a regular investment plan. If a recession hits the economy and your investment falls in value, you’d just end up buying more shares at a lower price.
But there are a few things investors should understand before starting your own dollar cost averaging plan:
- Dollar cost averaging is a strategy that is better suited for investors with a lower risk tolerance and a long-term investment horizon. This strategy makes the most sense when used over a long period time with volatile investments, such as stocks, ETFs or mutual funds, and makes less sense for bonds or money market funds.
- Also the strategy is no guarantee of good returns on your investment. Dollar cost averaging into an investment that continues to fall each and every month is not a wise move.
- Investing involves risk and your own due diligence, so you should only dollar cost average into an investment that you understand and are comfortable with. You shouldn’t just set up an automatic investment plan and forget about the investment, so probably you need to regularly check in on it.
Dollar cost averaging bad/good for retirement investing strategy
Traditionally for years dollar-cost averaging has been known as the go-to strategy whenever you need to invest a large sum of money. But when Vanguard delved into the numbers, it turned out that dollar-cost averaging wasn’t the clever strategy it’s cracked up to be.
According to the Walter Updegrave editor of the real deal retirement suppose you have a large sum of cash that you want to invest for retirement in a portfolio of 60% stocks and 40% bonds. To determine whether you would be better off investing your cash in that 60-40 mix immediately or gradually—say, over 12 months—Vanguard calculated how the two strategies actually performed over the 1,069 overlapping 12-month periods from the beginning of 1926 through the end of 2015. Those decades included bull markets, bear markets and just about every type of market in between that you can imagine.
The result was that investing the lump sum of cash in a 60-40 mix all at once won out roughly two-thirds of the time, outperforming dollar-cost averaging by a margin of 2.4 percentage points on average over the 12-month spans. When Vanguard’s researchers repeated the analysis, comparing the two strategies over longer periods (36 months) as well as shorter ones (six months) and with a target portfolio that was more aggressive (100% stocks) as well as ones more conservative (50% stocks-50% bonds and 100% bonds), they found that investing the cash immediately came out ahead again, besting tiptoeing in roughly two-thirds of the time or better in each scenario.
In short, the competition between investing immediately and a little at a time wasn’t even close. It was a total beat-down. Investing all at once left dollar-cost averaging in the dust.
The stock and bond markets tend to go up more often than they go down and they typically generate higher returns than cash equivalents like Treasury bills, money-market funds and savings accounts. So the longer you take to get the money you’ve decided to invest for long-term goals like retirement into investments, the greater the return you’re likely giving up.
But for those who advocate Dollar cost averaging investing gradually protect you when the financial markets do falter, thus making it a smart strategy if you’re risk-averse, and does provide some shelter against market setbacks. But it’s not a very smart way to get that protection.
Walter Updegrave says that the mix of 60% stocks and 40% bonds represents the tradeoff of risk and reward you consider appropriate for your situation. If you were willing to accept more risk in return for loftier gains, you would have invested more heavily in stocks. Also if you wanted more downside protection, you would have gone with a mix tilted more toward bonds.
If you put your cash to work by dollar-cost averaging into your target portfolio rather than investing 60% in stocks and 40% in bonds immediately, however, you are effectively contradicting your asset-allocation decision. For example, if you gradually invest your cash in monthly installments over the course of a year, you will have essentially gone through a monthly series of more conservative allocations of stocks, bonds and cash until you reach the 60-40 mix you’ve already decided is right for you.
You should look at what’s really going on when you dollar-cost average to your target portfolio risk rather than going to it immediately. Also some people may find it too hard emotionally to invest a sizable sum of cash all at once. They just don’t feel comfortable doing it. But if you’re in that camp, then at least try to get to your target portfolio as quickly as you can. Vanguard suggests getting to your target allocation within a year. say, within six months or, if you can manage it, three. Because the more you stretch it out, the longer your retirement savings won’t be invested the way you decided they should be.
Whether you’re adding new money to your portfolio or, as you’re doing, switching to a new stocks-bonds mix because the old one doesn’t suit you, you’re better off investing the money or moving to your target portfolio mix as quickly as possible rather than dollar-cost averaging.
If you find it psychologically or emotionally difficult to do that, then make the move gradually but over a short period, say, a few months instead of a year. Because the longer you string it out, the longer you’ll be taking more (or less) risk than you’ve decided you should take.
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.