W hat’s the best strategy for long-term investing? Is it dollar cost averaging? Lump sum investing or timing the market? In this article, we will be exploring dollar cost averaging. The benefits and downsides.
Benjamin Graham first coined this term in his 1949 book The Intelligent Investor. He stated, “DCA… means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter. In this way, he buys more shares when the market is low than when it is high, and he is likely to end up with a good overall price for all his holdings.” The book has been published for a long while, but the information is still very relevant to modern-day investors. One of these concepts includes dollar cost averaging, which has been instrumental in shifting new investors into longer-term investment strategies. To understand dollar cost averaging, we should know where it first gained traction.
An Example of dollar cost averaging would be as follows
After completing his session, Tim received $1,200 from an online focus group. Now that Tim is wondering how he would invest this $1,200. If Tim takes a dollar cost averaging approach, he will divide the $1,200 received into equal portions. Then he will set a recurring investment schedule (for this example, we will say monthly, although it can be daily, weekly, quarterly, etc.) on the first of every month for a year. So Tim would divide the $1,200 he has by 12 to give him his recurring investment of $100 per month.
This simplified explanation of what dollar cost averaging is, but it can help illustrate that it divides the total investible sum into equally distributed portions. Now that we know how it works, what are some of the benefits of this strategy?
Main Benefits of Dollar Cost Averaging:
- Reduce Volatility Risk
- Ability to avoid “timing the market.”
- Encourages Disciplined Saving
- Manages emotions more easily
Dollar-cost averaging can help keep your price per share price down, so you don’t purchase shares at a high point just to wait out a period for your investments to recover. It can reduce volatility when it is unknown whether a price will be higher or lower over the next few weeks. Along with reducing the price volatility, it also discourages the principle of holding onto cash in hopes that the market will be low enough to justify purchasing stocks. Some call this trying to “time the market,” which has historically not performed well. Another advantage of this strategy is it encourages saving regularly. Regularly saving money is very hard for the average person, so we have car insurance instead of a stack of cash under a mattress for emergencies.
Primary Downsides of Dollar Cost Averaging
- Higher Transaction Cost
- Lower Overall Returns than some strategies
- May “miss” the bottom of the stock price
- It can be hard to continue regularly if not automated
Contrarily, there are also a few notable downsides to dollar cost averaging. First off may be the transaction costs. Most financial institutions have been lowering or eliminating their fees for buying/selling stocks, but some have not. This means the more frequently you invest, the more often you will be hit with a fee for buying or selling stocks. Another disadvantage is some strategies may have a higher return on investment than dollar cost averaging. This can discourage some who want to create wealth quickly since it is slow and meticulous. A few other discouraging aspects are that you may “miss” the bottom of the stock price. This sounds bad because you always want a lower price. In the end, it is nearly impossible to predict the direction of a stock price and where it will move. Finally, keeping up with consistent investing can be challenging if it is not set on an automatic schedule.
Investing can be a fascinating venture, but it takes consistency and devotion to make it worthwhile. If you are considering starting an investment portfolio, I would recommend checking out some more information on dollar cost averaging from various sources. In the end, this has been the strategy I am the biggest fan of over the long run. As described above, it seems to do pretty well while minimizing my risk with the volatility of the stock market.
*Disclaimer, This is not financial advice and is created for entertainment purposes only
Resources
- Hayes, Adam. “Understanding Dollar-Cost Averaging.” Edited by Cierra Murry, Investopedia, Investopedia, 28 July 2022, https://www.investopedia.com/terms/d/dollarcostaveraging.asp.
- Lomax, Brian F . “Dollar-Cost Averaging (DCA): A Reappraisal.” CFA Institute Enterprising Investor, 29 Dec. 2020, https://blogs.cfainstitute.org/investor/2020/12/29/dollar-cost-averaging-dca-a-reappraisal/.
- Schwab.com. “Does Market Timing Work?” Schwab Brokerage, 15 July 2021, https://www.schwab.com/learn/story/does-market-timing-work.
Very insightful and informative loved the article.