An important part of investing is setting out a long-term strategy to follow. But is dollar cost averaging the best way to ease yourself in?
Long-term stock investing has been statistically proven to be anything but a gamble. For most newbies to the market, though, the thoughts of making that first investment are still quite scary.
The Financial Crisis remains fresh in the minds of many people. In fact, for a lot of investors, it remains the singular event that formed most of their opinions on the world of finance.
Business Insider recently reported that as many as 82% of 18-to-34 year-olds still find their approach to investing influenced by fears from the Financial Crisis.
This can lead them to adopt a much more conservative approach… or just not invest at all.
The biggest concern for most seems to be a fear of entering the market right before a downturn. Imagine the calamity of putting your life savings into stock investments on a Monday, only to see them fall by more than 20% by Friday (as happened with the Dow Jones during one of the worst weeks in 2008).
When you consider the record-breaking run the market has been on over the past few years, not to mention the legions of naysayers heralding the end of the financial world as we know it, it seems as though a lot of people are just waiting on tenterhooks for the drop.
But by staying out of the market, you’re also missing out on the possibility of very real returns.
So what’s the solution? Ease yourself in!
Dollar Cost Averaging?
Dollar cost averaging (DCA) is an investment technique that allows you to spread your investments out over a long period of time rather than making a few lump-sum investments. Typically, people tend to think of stock investing as using a lump-sum of cash to buy an entire portfolio of stocks in one go. With dollar cost averaging, however, you simply add a small amount of money to your portfolio every so often (usually weekly or monthly) and build up your investments gradually.
Dollar cost averaging has been made possible primarily through the rise in fractional share trading. Before fractional investing, an investor would have had to save up the full amount of a share in a company before they could invest in a stock. That could mean as much as $1,000 for one single share in a company like Amazon, for example.
However, with fractional investing, you can buy part of a share in a company for as little as $10. This means that you are no longer restricted by the price of individual shares and can just invest as much money as you want.
The central tenant of dollar cost averaging is that you invest money every week or month consistently. It doesn’t have to be a large amount, but it has to be consistent. In fact, it’s very similar to contributions you might make to your 401k or other pension plans.
Types of Dollar Cost Averaging
There are three primary types of dollar cost averaging: Basic DCA, Value DCA, and Momentum DCA.
Basic dollar cost averaging is, well… basic! It is the simplest type of dollar cost averaging and means that you invest the same set amount of money (a fixed dollar amount) into your portfolio every week/month — regardless of other happenings in the market. Once you have decided the amount you wish to invest and the frequency, all you have to do is decide what stocks the money will go into.
One important thing to understand with basic dollar cost averaging is the relationship that forms between the number of shares you buy and the movements of the market. If the share price of the investment drops in one particular month, you will end up buying more shares because the amount you are investing is still the same. Similarly, if a share price increases, you will get fewer shares per fixed dollar amount.
With Value dollar cost averaging, you still make regular investments on a predetermined schedule. However, the difference between Value DCA and Basic DCA is that the amount you invest changes depending on the performance of your stocks.
If the price of the stock(s) you’re investing in falls over the last month, you increase the amount of money you invest in it next time. If it rises, you decrease the amount. This means that you are increasing the number of discount shares you are getting by buying low and decreasing the number of expensive shares you are receiving by not buying when its high.
Momentum dollar cost averaging is similar to Value dollar cost averaging, but flipped around. So in this case, you decrease the investment after a negative month and increase the investment after a positive month. This allows you to ride on the wave of upward trending stocks and focus less on underperforming ones.
Why use Dollar Cost Averaging?
So what are the benefits of dollar cost averaging?
Well, as you’ve probably guessed by now, a big benefit of dollar cost averaging is that it allows you to ease yourself into the market. Dollar cost averaging doesn’t require you to commit a large lump-sum to the mercy of the public market straight away. Instead, you can just add in an amount you’re comfortable with (as little as $10 through our MyWallSt app) every month as you learn… kind of like a savings account.
Another major benefit of a dollar cost averaging strategy is that there’s less risk. Now, that’s not to say that you are less prone to the movements of the market than anyone else, of course. But the fear that your large investment will be wiped out straight away is removed.
Even when a downturn does come (which it inevitably will), your investments should have experienced enough growth to cushion any decline. For new investors, a dollar cost averaging strategy allows you to get skin in the game straight away while learning about and researching new companies.
A big draw for many long-term investors to dollar cost averaging investing is that it is a more passive form of investing compared to other investment strategies. Yes, you still need to find companies that you think will grow over the long term and research their fundamentals.
However, adopting a DCA strategy allows you to ignore day-to-day movements in the market and just keep consistently adding money to your portfolio. It takes the emotion out of the investing process (like panicking over little movements) and allows you to look towards the long term.
Does Dollar Cost Averaging work?
Various studies have been conducted into the efficacy of dollar cost averaging, and by-and-large they have proven that investing a lump-sum tends to be more profitable.
But there are some major caveats with this.
Looking objectively at investing and the market, investing a lump-sum in one fell swoop makes sense. Over the long-term (20+ years), it’s almost a statistical impossibility that the market will decline. This means that it’s obviously better to have, say, $3,000 invested from day one rather than the same amount built up in $50 per month investments over 5 years.
But this doesn’t take into account the subjective nature of investing.
Investing a significant amount of money like $3,000 is a big risk, which means that you’ll often find yourself antagonising over every single movement up or down in the market. More often than you think, this will lead people to panic and sell.
Dollar cost averaging might not always bring the most stellar returns, but it gives the comfort of a measured, incremental approach to investors who might not be prepared to jump in with both feet.
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MyWallSt operates a full disclosure policy. MyWallSt staff currently holds long positions in companies mentioned above. Read our full disclosure policy here.