What is dollar cost averaging: the best way to invest?

Want great investment advice? Buy low, sell high.

This desirable but overly simplistic strategy means that you must buy shares at a low price and sell them at a higher price, resulting in a profit from the trade. The problem with this kind of advice is that you need to know when to bottom in falling markets so you can buy, or when the market is peaking in order to make a profit.

This is the problem for most investors, which is difficult to achieve.

Why? Because we are busy people with emotional biases that react to market volatility. When the market is in a downtrend, people often fear further declines and sell their stocks. And when stocks rise, people have FOMO (fear of missing out) and they can rush to invest. For many of us, emotions and stress levels play a role in building our investment portfolio, which makes dollar cost averaging a legitimate strategy.

What is dollar cost averaging?

To succeed financially, you must develop long-term investment strategies. Avoid common mistakes when there is significant market volatility, such as trying to time the market, chasing the hottest trends, being overconfident, or setting unrealistic goals.

Our emotions get the best of us, especially when we make investments. To counter our propensity for trouble, we can adopt a safe and effective long-term strategy: dollar cost averaging.

Dollar Cost Averaging (DCA) is a systematic program investing equal amounts of money at regular intervals, regardless of the investment price. This is a simple approach that requires you to define two parameters: a fixed amount for each period and how often.

With this approach, you automate investing the same fixed amount in the same stock, ETF, or mutual fund at regular intervals over a long period of time.

Because investments tend to rise in value more than they fall, “cost averaging” means you buy more when the price is down and fewer shares when the price is high. In essence, you are buying most of the shares at below average prices.

You are probably already using the DCA approach

This strategy provides a disciplined approach, taking the guesswork out of investment timing and avoiding external events that can cause short-term market fluctuations. DCA is similar to a buy and hold scheme. investment strategies who look past the short-term noise in the market.

You probably already use dollar cost averaging for your 401K plans, individual retirement savings accounts (Roth IRAs or traditional IRAs), and employee shareholding plans.

Suppose you are using acornsmicro investment app, Greenlight application, or other fintech companies that use the summary feature or recurring investments. When making purchases using a linked debit card, the change from the transaction is rounded to the nearest dollar and credited to your investment account. Users will benefit from using an average dollar cost strategy.

In addition to these plans, a dividend reinvestment plan (DRIP) can perform dollar cost averaging. Many high-profile companies, such as Coca-Cola, allow investors to buy dollar-priced shares directly from them through the DRIP program, which is administered by the Direct Equity Buy Plan Clearinghouse. This avoids going through a brokerage firm. DRIP strategies help investors reinvest their dividends.

While dollar cost averaging is not an exciting way to invest, it generally allows investors to buy at “below average” prices. For example, you can invest $100 in the stock of a certain company every month, whether the market fluctuates, falls or rises.

After six months, you have invested $600 in stocks at an average dollar value of $3.87 per share. If you were to invest $600 all at once, your average price would be $5 per share, which is higher than the average price of $3.87. Below we will discuss investing in lump sums.

MONTH $ AMOUNT SHARE PRICE OF PURCHASED SHARES

MONTH	AMOUNT $	SHARE PRICE	SHARES PURCHASED
JANUARY	100 dollars	$5	twenty
FEBRUARY	100 dollars	$5	twenty
MARCH	100 dollars	4 dollars	25
APRIL	100 dollars	$5	twenty
MAY	100 dollars	2 dollars	fifty
JUNE	100 dollars	4 dollars	twenty
GENERAL	600 dollars		155

Benefits of dollar average cost

Reduces risk

The DCA approach minimizes risk and is desirable for investors with low risk tolerance. It automatically buys more shares through recessions and lower prices, reducing the average share price. Basically, it provides short-term fall protection using gyrations.

Investor discipline

This simple strategy improves investor discipline.

Investors make purchases at regular intervals and for fixed amounts instead of untimely one-time investments. Investors do not calculate the market, which is a problem for the most sophisticated investors. They can set up automatic contributions based on their preferences, just like they do for their retirement accounts.

Warren Buffett is a fan of the “low average cost” approach. Whether he’s buying stocks for his own portfolio or encouraging investors to buy low-cost S&P 500 index funds, he often says that investors shouldn’t buy everything at once.

Help you lower your base cost

Average dollar values ​​reduce the average value of stocks acquired in the relatively long term. Investors will buy more shares at a fixed price when the market goes down. Until it’s liquidate losses, this strategy limits them during price declines.

Reduce emotional bias

DCA is opposed to the psychology of investors, sometimes referred to as behavioral finance. We often buy at the “wrong” time and anticipate our movements in the market. Investors are afraid of losses cognitive distortion it describes people who experience the pain of loss far more than the pleasure of acquiring the shares they own.

Similarly, the anchoring bias forces us to rely on the first piece of information we know rather than new information. For example, an investor may refuse to sell shares at a lower price than they bought them. They may cling to the higher price they paid, even if new information points in an unfavorable direction for the company.

Dollar-Value-Averages provide a mechanism that removes emotional biases that can undermine our portfolio strategy.

Less attention to short-term market volatility

Market volatility can cause stress. DCA smooths out volatility by regularly buying shares at a lower price. Investors can better ignore the daily noise affecting the market.

Putting money into your portfolio during a sharp a market downturn is often the best time to buy stocks.

The DCA approach allows investors to stay in the market, rather than being sidelined and bottoming out. You can’t wait for the “dust to settle” as there are no bright lights to tell you when to return to the market.

Disadvantages of dollar cost averaging

More conservative approach

The lack of DCA glamor can be tiring for some investors who prefer to actively trade stocks on shorter time frames. The Dollar-Value-Average strategy is generally a more conservative way of investing than lump sum investments.

Investors may miss out on higher returns

Less risk, as a rule, brings less profit. Therefore, DCA investors may miss out on the higher returns associated with a riskier lump-sum investment strategy.

Investors will earn higher returns if the price of an asset rises by investing a lump sum at a lower price rather than at regular intervals. In the DCA strategy, you can buy fewer shares than if you had made a larger investment up front.

Opportunity costs are possible

With a DCA approach, you can hold funds in cash or money markets (cash equivalents) at meager returns, resulting in an opportunity cost. You can avoid this scenario by contributing to your portfolio from your paycheck, just as you do with your retirement accounts.

Comparison of DCA results with lump sum investment

An alternative to DCA is lump sum investment. This is when you immediately invest a lump sum, as opposed to DCA which invests equal amounts at regular intervals.

Northwest Team analyzed a rolling 10-year return of $1 million immediately invested in US markets compared to the average dollar value. In the dollar cost averaging scenario, money was invested evenly over 12 months and then held for the remaining nine years. They ranged from 100% equities or 100% fixed income, including money markets, to a 60/40 split between equities and fixed income.

They found that investing a $1 million windfall immediately yielded higher cumulative total returns at the end of 10 years than averaging dollar costs almost 75% of the time. This was regardless of asset allocation.

However, another study pointed out that the length of time for DCA matters. Over 36-month intervals, the lump sum exceeded the dollar value, on average more than 90% of the time. However, the results were much closer on a six-month time frame.

DCA works best for six to twelve months, while lump sum investing works best with large windfalls, such as inheritance or insurance, and longer periods.

Who Should Consider the Dollar Cost Averaging Strategy

• The DCA approach is best for beginners and risk-averse investors who want to participate in the market and cannot tolerate cumulative losses.
• They are comfortable with lower returns in exchange for higher risk and stress.
• Investors do not need to time their purchases.
• They prefer to automate contributions to build their portfolio and do the same for theirs. retirement accounts.

Although DCA works with individual stocks, buying ETFs or mutual funds is desirable for diversification purposes.

Final Thoughts

Dollar cost averaging is a conservative approach to market investing that reduces risk, stress, and emotional bias. This is desirable for investors who are less tolerant of market volatility but want to participate in the market.