On why dollar-cost averaging may feel safe but usually leaves investors worse off than investing a lump sum upfront.
Investing can be tough, especially for those who try to time the market for the best deals and sometimes miss out.
Dollar-cost averaging, or, in most of our cases, pound-cost averaging, is a smart strategy that helps navigate unpredictable markets by automating purchases.
It also encourages investors to stick to a routine of investing regularly.
Timing the Market Is Risky
The general consensus in financial circles is that trying to time the market is risky and often ends up being a losing strategy.
Perhaps you can time the perfect moment to buy into a stock, but that still leaves the challenge of needing to sell at the right time, too.
You need to be right, twice.
Over the course of time, doing this consistently proves to be very difficult.
Financial experts caution against this for several reasons:
- Predicting short-term movements in the market is tough because it’s influenced by many things, like economic indicators and global events.
- The Efficient Market Hypothesis adds another layer, suggesting that asset prices already include all available information, making it hard to consistently spot undervalued or overvalued assets.
- Emotional reactions play a big role in short-term market changes.
- Trying to time the market involves making decisions based on predicting how others will act, which can obviously be unpredictable.
- Frequent panic buying and selling assets can lead to extra costs and taxes, eating into your overall returns.
Taking a long-term approach has historically been more successful, as it helps you ride out the ups and the downs.
Trying to time the market consistently is tough, even for experienced professionals, and doing so might cause you to miss out on opportunities for potential gains if you’re waiting for the perfect moment to jump in or out.
So this leads to the natural solution: dollar-cost averaging.
What Is Dollar-Cost Averaging?
Dollar-cost averaging is like putting your money on a roller coaster ride, but in a smart and steady way.
Instead of trying to time when to invest based on the ups and downs of the market, with dollar-cost averaging, you decide to invest a fixed amount of money regularly, no matter what’s happening with the price of stocks or other investments.
This strategy helps you stay calm when markets get crazy.
And here’s why:
- When prices are high, your fixed amount buys fewer shares.
- When prices are low, it buys more shares.
This way, over time, the average cost of all your shares becomes more stable.
Dollar-cost averaging takes the stress out of trying to predict the perfect moment to invest.
It’s like setting up a little savings plan for yourself.
Plus, while you’re buying a bit at a time, you’re less likely to make rash decisions based on emotions, which can be a real challenge in the world of investing.
Anyone can dollar-cost average into their investments, whether they have a lot or a little money to invest.
It’s a straightforward and accessible way to get into the investing game.
But keep in mind: while dollar-cost averaging is a sensible strategy for long-term investors, it’s not a magic technique that will guarantee you make a profit.
Always consider what’s happening in the market, any fees you might pay, and how taxes might play a role when you decide to give dollar-cost averaging a try.
The Pros and Cons of Dollar-Cost Averaging
Although this method can assist in risk management, the likelihood of achieving exceptionally high returns is lower.
Evaluating the pros and cons of dollar-cost averaging can aid investors in deciding whether it aligns with their investment strategy.
The Pros
Avoids Emotional Decisions
Using a dollar-cost averaging strategy means you invest the same amount regularly, regardless of how the price goes up and down.
This way, you don’t let your feelings guide your investment choices.
Even if the price suddenly drops, you stick to your plan, and you see it as a chance to get more shares at a lower cost.
Minimises the Impact of Bad Timing
Putting all your money into a single asset at once comes with the risk of investing just before the market takes a downturn.
For example, if you’d invested right before the 2007 market downturn, you would have faced more significant losses compared to investing only a portion of your money earlier on.
This approach also means you might not catch the opportunity to invest a substantial amount just before the market starts rising in a bull market.
However, since accurately timing the market is difficult, dollar-cost averaging emerges as a practical strategy, reducing the impact of market volatility.
The Cons
Markets Generally Increase Over Time
One drawback of dollar-cost averaging is that, since markets tend to rise generally speaking, investing a large sum earlier often performs better than spreading small amounts over an extended period.
For instance, consider what happens after investing £5,000 all at once in a stock that annually increases by about 10% at the start of a 10-year period.
This would be financially more advantageous than investing the same amount gradually over time, such as £500 per year.
It is Not a Replacement for Finding Sound Investments
Dollar-cost averaging doesn’t eliminate all investment risks.
Even if you choose the passive approach of dollar-cost averaging, you still need to pinpoint good investments and conduct thorough research.
If the asset you choose turns out to be a poor investment, you’ll consistently invest in a losing venture, essentially just dollar-cost averaging down.
By following a passive strategy, you won’t react to market ups and downs, whether they’re positive or negative.
As the investment landscape evolves, you may come across new information about an investment that prompts you to reconsider your approach.
Reducing Risk with Dollar-Cost Averaging
Dollar-cost averaging can also be used if you’re the type of investor who doesn’t like risky investments.
It spreads out the prices at which you buy your investments, making things less risky.
Since none of us can see into the future, using dollar-cost averaging is a safer bet because it doesn’t depend on guessing what the stock market will do.
It’s a bit like having a safety net that protects you from the ups and downs of the market, making your investment journey a bit smoother and less uncertain.
Investing Windfalls
When you suddenly come into a big chunk of money, like an unexpected windfall, it’s an emotionally easier move to invest it gradually rather than all at once.
This helps minimise the volatility that comes with the ups and downs of the market.
Instead of putting everything in at a single moment, you spread out your investments over time.
This way, you’re not trying to guess the perfect time to invest, and it provides a more stable and less risky path to grow your money.
It’s tough to see your money fall only days after you put it into the stock market.
It’s a lot easier to manage mentally if you only invest a little bit of the total sum initially and still have more to add as time goes on.
On top of the mental benefits, with dollar-cost averaging, you can set up a plan for regular contributions and then pretty much forget about it.
Once it’s all set, your investments grow without needing constant attention.
This approach frees up your time and lets you concentrate on other parts of your life, while your money keeps working for you in the background.
It’s like putting your finances on autopilot, making things more convenient and allowing you to pursue other interests without worrying about the day-to-day of your investments.
Is Dollar-Cost Averaging a Wise Strategy?
Yes, it can be beneficial, but most of the benefits, in my opinion, are more on the emotional side rather than the practical finance side.
So, why don’t I do it?
In my opinion:
- If you’re investing in individual stocks, dollar-cost averaging doesn’t make sense.
- And if you’re investing in index funds or ETFs, then lump-sum investing is technically a better strategy, historically and mathematically.
Let me explain what I mean.
For Individual Stocks
When you buy an individual stock, you’re making a statement about its price versus its value.
By buying the stock, you’re saying that you think that the current price is necessarily below its current value.
Just like when you buy anything, you believe you’re getting something of more value than you believe your money is worth.
Of course, this is true; otherwise, you would keep the money or buy something else instead.
So, what’s the purpose of deliberately holding back money that you think is less valuable than the stock you’re looking at?
You might believe there’s a risk that the price will go down lower than it currently is and want to hold off just in case.
A better way to think about this is to make a plan to decide how much you want to own of it and then try to accumulate to that level, rather than thinking about whether now is the optimum time to buy or whether to hold off.
It could go up in the opposite direction, and then you’re averaging up instead.
Personally, I think it’s better to think in terms of buying what you want to own.
If you have money and you think the price is good, then buy it; don’t regret it afterward.
As such, you now own something that you wanted.
There are going to be a million “could have, should have, and would have” moments in life.
So, as long as you’re following your plan or strategy, the short-term drop in prices doesn’t need to bother you that you “timed it wrong.”
For ETFs or Index Funds
ETFs are harder to value, as there are many components, and some will be up, and some will be down.
So, I think buying in increments over time makes sense.
However, I don’t advocate leaving cash that you would want to invest lying around just for the sake of dollar-cost averaging.
Just lump-sum the amount you want to invest shortly after you get paid.
As Nick Magguilli writes in a blog post:
“This question comes up a lot when we’re chatting with clients. I understand the fear they may have around investing this money—and there’s a lot at stake: hundreds of thousands, maybe millions of dollars. What if the market crashes right after you invest? Wouldn’t it be better to average in over time to smooth out any unlucky timing on your part?”
Statistically, the answer is no.
Vanguard found that 68% of the time, it’s better to invest your money right away rather than buying in over 12 months.
The main reason lump-sum outperforms dollar-cost averaging is that most markets generally rise over time.
Because of this positive long-term trend, dollar-cost averaging typically buys at higher average prices than a lump sum.
Additionally, in those rare instances where dollar-cost averaging does outperform lump-sum, i.e., in falling markets, it’s difficult to stick with dollar-cost averaging.
So, the times when dollar-cost averaging has the largest advantage are also the times when it can be the hardest for investors to stick to their plan.
That means, statistically, holding money aside to invest later is a losing proposition.
So while there may be some emotional benefit to doing it this way, and you feel better about doing it that way, it usually is going to end up worse off for your finances.
Final Thoughts
Attempting to time the market is a challenging task, even for seasoned professionals, and it often proves to be an unreliable strategy.
The unpredictability of market movements and the multitude of factors influencing them make it difficult to consistently make accurate predictions.
While there are no guarantees in investing, dollar-cost averaging aligns with the principle of discipline and long-term investing, making it a compelling choice for those seeking a reliable strategy to navigate the complexities of the financial markets.
Though at a higher level, it may not be as great as it may first seem.