Don’t time the market: The magic of dollar cost averaging
Dollar cost averaging is one method to help reduce volatility. By spreading out the purchase of stocks or funds over time, you can avoid buying them at their peaks.
How dollar cost averaging works
Take for example, you want to invest $10,000 in a stock. Instead of investing everything in one lump sum, you can split it into $2,000 a month over a period of five months, or $1,000 a month over a period of 10 months.
As you are unable to outguess the market, you will not be able to gauge if the prices will fall, remain constant, or rise in the next five or 10 months. However, you can gain control of the situation by averaging out risks. Examples of dollar cost averaging includes a regular contribution to a savings plan from any financial institution.
The good
Capital markets have the tendency to reward long-term investors that practise dollar cost averaging. It takes the emotions away from the decision-making process and helps to manage risk.
Emotional Management
Managing emotions is the secret to becoming a good investor. By investing habitually and mechanically, you can remove the emotional aspects from your decision-making process.
This way, price swings will not result in fear or greed, and instead, is a chance to purchase more shares at a lower cost. You take away the guesswork and impulsiveness commonly associated with investing.
Safety Net
Dollar cost averaging is the only sure way to not invest all your money at a high, prior to a big downturn, or during periods of high volatility. It is a form of safety net that puts the mathematical odds in your favour.
Take the below calculations for example:
An example of dollar cost averaging in action.
In the scenario above, if you had purchased the stock in one lump sum at its highest ($1.25), you would only own 8,000 of its shares. With dollar cost averaging, you’re paying on average $0.94 for each share, and will own about 11,200 shares.
If you are now thinking that you should simply invest in one lump sum at the lowest price point ($0.6), you may be susceptible to hindsight bias, which is a common psychological trap while investing.
Chu Chui Laam, Senior Financial Consultant of LFA recalled, “I had a client who wanted to exit the market in April this year in hopes of re-entering when the situation gets worse. I advised him against it, and after much discussion, we decided to stick to our dollar cost averaging strategy. The next thing we knew, the market picked up since April and has been going strong.”
“There is no clear right or wrong when it comes to investments. However, here at LFA, we are in the business of financial planning. We are not seeking to gamble your wealth away, or to time the market blindly. We are looking to grow your profits steadily and sustainably without falling prey to speculations, to provide you with a solid, long-term financial plan that allows you to maintain and improve on your current lifestyle.”
Long-term exposure
In the long run, the steady exposure to stock markets can deliver high probabilities of success. Historically, stock markets rise over time. The aggregated stock index, Straits Times Index (STI), has reaped an average annualised return of 9.2% per year over the past decade, excluding dividend payouts of about 3% per year. In the same timeline, the S&P 500 also delivered similar returns at 9.1% per year.
This makes dollar cost averaging a proven strategy for busy investors who are unable to monitor their investment portfolios regularly.
The bad
Dollar cost averaging is not a cure-all or substitute for identifying good investments. The profits generated may also not be attractive to high risk investors.
Limited profits
While you can avoid buying at a high, you also lose out on the opportunity to buy a lot of stocks at its low during market meltdowns. This means that while your returns can be protected through risk management, they can also be limited by it.
Since stock markets tend to go up in the long run, the lump sum invested earlier on is also likely to perform better than the smaller amounts invested over a period of time.
Trading costs
Buying more frequently translates into more trading costs, which adds up. This is where looking for brokerages with low trading costs are important in managing expenses. At LFA, clients are not imposed with a sales charge, ensuring that the full amount is invested.
Due diligence is still required
Dollar cost averaging is not a one-stop solution for all investment risks. As a responsible investor, you will still need to identify good investments by being mindful of the fundamentals of a stock and its performance before investing. It is still important to find a strong stock suitable for this passive strategy, or you may risk losing returns steadily.
A bad stock is a bad stock, regardless of which strategy you employ. If it is on a prolonged downtrend or sideways trend, any lump sum or dollar cost averaging strategy will not change your losing portfolio.
The bottom line
Every investor can afford to incorporate dollar cost averaging into his portfolio. Particularly in the uncertain post-COVID era, where tides come and go, dollar cost averaging may be the prime instrument to managing risks.