Is Dollar Cost Averaging the Right Investment Strategy for You?
Dollar-Cost Averaging (DCA), also referred to as unit cost averaging, incremental averaging or cost average effect, is an investment strategy intended to minimize the impact of volatility when investing. What is dollar-cost averaging, what are its benefits and drawbacks, and is this investment strategy best for you? Read this article to learn more.
What is Dollar-Cost Averaging?
DCA reduces the impact of short term stock price volatility by spreading out the purchase of market securities over time. Rather than making a lump-sum purchase, securities are purchased in fixed amounts at specific intervals so that you are not purchasing them all at the same point of time in the market cycle.
The goal is to benefit the investor overall if, over time, the stock price increases beyond the average purchase price paid by the investor.
Benefits of Dollar-Cost Averaging
“Systematic investing will pay off ultimately, provided that it is adhered to conscientiously and courageously under all market conditions.” – Benjamin Graham
1. Risk Reduction (Avoid Mistiming the Market)
DCA reduces investment risk (volatility) and capital is saved in the event of a market downturn. It mitigates the disadvantage of lump-sum investing resulting from making a total purchase of a security when its price may be at or near its peak. DCA avoids market timing risk.
2. Lower Cost
By using DCA and investing a fixed amount of money at regular intervals, you will be purchasing more shares of a company as the price goes down. Therefore, you will benefit more when the price goes up as you will have purchased a greater number of shares at a lower average cost than if you had made a one-time lump-sum purchase before the downward trend.
3. Riding Out Market Downturns (Taking Emotion Out of Investing)
By investing periodic smaller amounts in declining markets, DCA assists in riding out market downturns. You will be buying stocks when other investors are fearfully selling. As in (1) above, you will also be buying at a lower price and be well positioned to benefit when the price goes up. Adhering to a DCA program removes emotion from the investment decision by constraining the impulse to act on short term market changes.
4. Sticking to Your Plan (Long-term Investment Discipline)
Investors are usually hesitant to invest more when the market is going down. When everyone is selling there is a lot of market uncertainty. The disciplined strategy of adding money regularly to an investment account removes opportunity for short-term reactions. While it’s difficult to invest against the crowd, when the market recovers, you will have done much better than the crowd.
A DCA strategy helps investors stick to their investment plan without the opportunity to second guess decisions or consider external influences. By continuing to invest, they will benefit over the long-term, more than the market-timing crowd.
Drawbacks of Dollar-Cost Averaging
1. Not Fully Investing in a Rising Market
When you use DCA as an investment strategy, you are keeping your money out of the market for the period of time between your regular purchases. You could be losing out on growth opportunities if the price of your investments is continuing to go up. As the price goes up, you are also buying fewer shares.
2. Opportunity Cost of Holding Cash
Another drawback of DCA is the opportunity cost of holding cash out of the market. As you stick to the DCA plan, you may be missing out on dividends and the benefits of compounding in addition to price growth over the investing period compared to if you had invested the lump-sum initially.
3. Applying DCA Without Fundamental Research
DCA could prove counterproductive if you are investing in a stock without researching the underlying company. The DCA strategy will continue buying more stock when company fundamentals may be telling you to exit the stock.
Is Dollar-Cost Averaging Best for You?
Investing money lump-sum would magnify gains in an upward trending market but would also magnify losses in a downward trending market. DCA reduces the likelihood of getting an extreme outcome from a lump sum investment, whether positive or negative, but is dollar-cost averaging best for you?
For most people the anguish of losses is greater than the joy of gains—in other words, the negative impact of financial losses can be greater than the positive impact of financial gains. After all, you’ve worked hard for your money and a downturn in the market can quickly erase much of your investment.
Knowing whether DCA is the right investment strategy for you depends heavily on your risk tolerance and your investment time horizon.
Preserve and Build Your Wealth with Bloom
At the end of the day, whether you apply DCA or another investment strategy, depending on your risk tolerance and investment time horizon, the thought of putting all or most of your money in the market at once may be stressful. It may be best to turn to a professional investment manager to help you. Bloom Investment Counsel, Inc. practices patience and prudence in its investment process.
Founded in 1985, Bloom Investment Counsel, Inc. has experience in managing in excess of $2.5B in assets over the years. Our clients include wealthy individuals, family offices, foundations, corporations, institutions and trusts who have trusted us to protect, preserve and build their wealth over the long term in a way that aligns with their unique, personal financial situations. Let’s talk to discover the best investment approach for your situation.
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This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.