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Investing strategies: How dollar-cost averaging makes you money
They say that time in the market beats timing the market. Dollar-cost averaging allows you to take advantage of this, but like all investment strategies it comes with some risks
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When it comes to investing there are multiple strategies that you can follow. One that is becoming particularly popular amongst retail investors is a process known as dollar-cost averaging. It allows you to take advantage of time in the market, while also adding discipline to your investing by forcing you to consistently buy even during volatile markets.
But before you start, here is what you need to know about dollar-cost averaging.
What is the dollar-cost averaging?
Dollar-cost averaging is an investment strategy that involves contributing a fixed amount to a fund or stock portfolio at regular time intervals, regardless of share prices or market movements at any given time.
When the prices of your chosen stocks or funds go up, your fixed investment will buy fewer shares. When prices go down, it nets you more shares and reduces your average cost per share over time. This way, your investment isn’t as highly impacted by volatility as it would be if you purchased all your shares in one lump sum.
Essentially you're betting that markets go up over time.
While the past might not be repeated in the future, the ASX200 has delivered 9.7% per annum including after downturns such as the dot.com bubble and COVID-19. To see how your money could perform click here. As such, this is often practiced with index funds, so that you're dropping money into the ASX200 or the Nasdaq Composite regardless of the price at the moment.
The major advantage of dollar-cost averaging is the guesswork is removed by constantly adding to the market regardless of the state of the market.
Simple dollar-cost averaging calculator
Using dollar-cost averaging
Let’s say you decide to invest $1,000 in stock ABC on the first of every month for five months. Assume the following table indicates how the price of the stock moves in the first five months.
|Month||ABC stock price||Shares purchased||Shares owned||Value of investment|
By May, a total investment of $5,000 ($1,000 X 5 months) is worth $5,527.50. Had you decided to invest that total at any one of those months, your investment may be larger or lower. In this case, the average price of the stock was the same as the purchase price. But it’s lower than the stock’s highest price.
By using this strategy, you reduced the impact of volatility in the share price over time. Although it should be noted, the share can continue to fall meaning you would own more of the underperforming share over time.
Benefits of dollar-cost averaging
Dollar-cost averaging steers you away from the risk of market timing. Because you’re investing a fixed amount at different intervals regardless of share price, you avoid emotional investing or buying more shares as prices rise and panic selling when they drop. Dollar-cost averaging keeps you on a steady, long-term investing strategy.
If you've bought quality assets and you believe over the long-term markets go up, then dollar-cost averaging actually allows you to reduce risks. This is in two ways, one it will stop you adding a lump sum of cash to the market at any time, giving you more flexibility and two, while you'll still experience a loss during a downturn it ensures set losses. This stops traders wiping themselves out in one bad trade.
It also forces you to become a saver. If you diligently stick to a dollar-cost average strategy you'll be forced to save. Say for example you want to add 10% of your paycheque to the market. By immediately adding 10% of your money every paycheque this money will be saved for a future occasion.
Another major perk is it allows you to avoid bad timing. We can all be unlucky and invest just before a share or the entire market falls. But by dollar-cost averaging you're putting the same amount of money in each time regardless of market conditions. These smaller amounts more often protect against bad timing.
You might not be familiar with the concept but if you're an Australian citizen you're probably already taking advantage of this strategy. This is because our superannuation system is designed around this. Your employer takes 10% of your money out of your check every payday and invests it in the shares and various other assets with the aim of funding your retirement by the time you're 67.
Downside of dollar-cost averaging
Succeeding in dollar-cost investing assumes share prices will rise, at least in the long run.
But prices are constantly moving, and nobody can predict where they’re heading. So engaging a dollar-cost averaging strategy on a shares you know little about can be especially risky. You may end up buying more shares at a time when an exit would be more suitable.
You'll also unfortunately face higher transaction costs. This is because you'll be trading more often when compared with adding a lump sum.
It also take out timing the market. While for many retail investors it is a positive. It also has a major drawback being you'll be buying when markets fall. Theoretically, this could lead to a lower overall returns, especially compared with someone who keeps their powder dry during a market fall and buys near the bottom. Although it is worth noting even the very best struggle to time the market.
When is dollar-cost averaging most appropriate to use
While pretty much any retail investor can in some way benefit from regularly adding money to a share portfolio, this strategy might be more suitable for index funds or mutual funds. This is because you'll constantly be adding to a basket of shares instead of one individual company for that time period.
At the same time, this strategy also helps investors ensure they add to all their stocks over a given timeframe. While for most putting money into say 20 or more individual positions might be too much every paycheque, a dollar-cost average approach can still be beneficial. You'll just need to average your investment over a number of pay cycles or simply invest in the best idea at the time.
But in either case, it’s crucial to examine the fundamentals of any investment before employing a strategy.
Moreover, dollar-cost averaging is best used as a long-term strategy. While markets are in constant flux, prices generally don’t change much in the short term. You have to keep your dollar-cost averaging strategy in play through a long period to benefit from the low prices of a bear market and the high prices of a bull market. Either can last several months or even years.
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Dollar-cost averaging is the process of dividing your total investment in a stock or fund into fixed investments at set time intervals. When done correctly, it can help you hedge against volatility and earn strong profits in the long run. Before you invest, compare stock-trading platforms to find one that’s right for you.
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