There are a few purposes of dollar cost averaging, but the most common is to smooth out the effects that sporadic investing can have on the overall value of a portfolio. By buying small amounts of an asset at fixed intervals, an investor can reduce the risk that they will over- or under-pay for an investment.
Dollar cost averaging is a good strategy because it allows you to invest in a security at regular intervals and at an average price. This technique can help reduce the effects of market fluctuations on your investment and can also reduce the overall cost of investing in a security. It also means that you will buy more when prices are down and less when prices are up. This makes your average price lower, full stop.
As an example, an investor could choose to invest $1000 of their savings in a given ETF every month.
Dollar-cost averaging can be applied to any type of security including stocks, bonds, mutual funds, and exchange traded funds. Before we explain what makes it a good long-term strategy though, let’s have a look at some of the downsides.
The Downsides Of Dollar-Cost Averaging
1. It can take longer to reach your investment goal. If you’re investing for a specific goal, such as retirement, you may not reach your goal as quickly if you’re using dollar-cost averaging. This is because you’re investing small sums of money over time instead of investing a lump sum all at once. That said, it can fit well with a saving strategy.
2. You may miss out on some potential gains. In a rapidly rising market, dollar-cost averaging can leave you behind since you’re buying fewer units when prices are high. For example, let’s say the market is rising by 10% each year and you have $10,000 to invest. If you invest all at once, you’ll end up with $11,000 after one year. However, if you use dollar-cost averaging and spread your investment out over 12 months, buying $833 per month, then your total investment will only be worth a little more than $10,556 at the end of the year – missing out on those extra four percent (and change) in gains. You will have a slower start, but over time you will benefit from market fluctuations.
3. There are transaction costs associated with each purchase. When using dollar-cost averaging, it’s important to remember that there may be transaction costs associated with each purchase (e.g., brokerage fees). These costs can eat into your overall returns and should be taken into account when deciding whether or not dollar-cost averaging is right for you. It would be wise to find a low-cost or a no-cost broker for such purchases.
The Benefits of Dollar-Cost Averaging
1. It takes the emotion out of investing. When you invest a lump sum all at once, you may be more prone to letting your emotions guide your investment choices. If the market drops shortly after you make your investment, you may feel panicked and sell your investment at a loss. Dollar-cost averaging can help take some of the emotion out of investing by spreading out your purchase over time. This is an immense advantage for the type of investor that worries about short term fluctuations in asset prices.
2. It can be easier on your wallet and it is easy to budget. Investing a lump sum all at once can sometimes be difficult if you don’t have a lot of extra cash on hand. By dollar-cost averaging, you can gradually grow your investment over time without having to come up with a large amount of money all at once.
3. You’re buying more when prices are low and less when they’re high. One benefit of dollar-cost averaging is that it automatically forces you to buy more units when prices are low and fewer units when prices are high. Over time, this can lead to an increase in your overall returns.
The Bottom Line
- Investing small amounts of money at a time is the perfect situation for most people in a capital accumulation phase.
- Automatizing a mix of ETFs, or just one, makes it very easy and mindless, and perfect for budgeting and saving.
- This method has built-in short-term market fluctuations mitigation.
- The strategy can compound into enormous gains over time.
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