When it comes to investing, you’ll hear lots of advice. Some of it will seem contradictory, and other bits will be right in line with what you expect to hear. When you invest money, you have many options available to you. For example, do you invest your money all at once, or do you spread it over time? This strategy is known as dollar-cost averaging (DCA).
This article explains what dollar-cost averaging is and the pros and cons associated with this investing technique. Read on to find out whether dollar-cost averaging might be a good strategy for you.
What Is Dollar-Cost Averaging?
Dollar-cost averaging is an investment strategy that involves making periodic investments in a given asset over a set period. This periodic investment can be done monthly, quarterly, or even annually. By investing in this way, investors can take advantage of fluctuations in the market by acquiring assets when they are priced low and selling them when the price goes up. Spreading out purchases over time helps to reduce the impact of any dramatic price fluctuations.
The strategy can be effective in the long run, but it’s only recommended for those who plan to hold their investments for at least five years. A key part of dollar-cost averaging is that it’s not a hard-and-fast rule. You can change your investment schedule to suit your needs as long as you stay consistent with your plan overall.
Pros of Dollar-Cost Averaging (DCA)
Below are three reasons why dollar-cost averaging is a worthwhile investment strategy.
Minimises Investment Risk
The dollar-cost averaging strategy is a simple yet effective way to minimse investment risk. By investing money at regular intervals, you can buy more shares when the price is low and fewer when the price is high. This approach helps to reduce the risk that you may face if you make all of your investments at one time.
You can set up a recurring monthly deposit into your investment account. This way, you can protect your money from sudden market swings. It’s important to note that dollar-cost averaging doesn’t guarantee that you won’t lose money. But it’s a good way to stabilise your investment portfolio.
Removes Emotional Attachment From the Investment Process
If you’re prone to emotional investing, then you’re more likely to buy more stocks when the market is high and less when the market is low. When you buy at peak price points, you may suffer significant losses if the market takes a tumble. And if you fail to buy at lower prices due to fear of further price plunge, you could miss out on a profitable investment opportunity.
One way to remove emotional attachment is dollar-cost averaging. Setting up a regular investment schedule regardless of price fluctuation removes any emotional attachment from the investment process. This way, you get to make more rational and profitable decisions.
Prevents Bad Timing
One of the biggest risks investors face is investing at the wrong time. The market can be unpredictable, and timing an investment can be difficult. It’s easy to get caught up in excitement over a new product or company or to get spooked by bad news. When this happens, it’s tempting to try to time the market for a quick profit. This could lead you to buy into a new product or investment at the wrong time, before it has had a chance to take off or before bad news has had a chance to fully sink in.
This can lead to losing money on a missed opportunity or failing to take advantage of the full value of your investment. A dollar-cost averaging strategy can help you avoid this mistake by spreading out your investment over time.
Cons of Dollar-Cost Averaging
Like any other investment strategy, dollar-cost averaging has its shortcomings. See them below.
Higher Transaction Costs
One downside of dollar-cost averaging is that it can increase your transaction costs. By buying at regular intervals, you will pay brokerage fees each time you make a purchase. Most full-service brokers charge 1% to 2% of the total purchase price. Some charge a flat fee, or a combination of both, for stock purchases. These fees can add up over time and eat into your returns.
Yields Lower Returns
DCA can also lead to lower returns over the long run. This is because you’re essentially leaving a substantial portion of your money idle by buying more shares when prices are low and fewer shares when prices are high. Additionally, when the market is volatile, dollar-cost averaging can result in a higher tax burden because you’ll be buying more shares when their value has fallen.
There’s No Guarantee That Dollar Cost Averaging Will Work
Although dollar-cost averaging is a great way to smooth out the ups and downs of the market and reduce risk, it isn’t a catch-all strategy that works in every situation. If you invest in a stock that continues to decline, you’ll eventually lose the total amount invested, whether or not you bought at intervals.
When you carefully evaluate what you stand to gain or lose with DCA, you can decide whether it’s the best investment strategy for you. DCA works best with long-term investments like a retirement account. Most importantly, perform thorough research on the asset you plan to invest in.