Dollar Cost Averaging:An Investment Strategy Mitigating Market Fluctuations
Looking for an investment strategy to negate the risks of market fluctuations? Then, you may find dollar-cost averaging investment strategy useful. It is the strategy of buying a fixed amount of a specific investment e.g. stocks, exchange-traded funds (ETFs) or mutual funds on a regular basis irrespective of the asset’s price - which is suitable for long term investment. This mitigates the risk of market fluctuations in investment, resulting in losses less frequently because you split your purchases and make multiple buys, making it more likely for you to pay a lower average price over time. Are you interested to learn more? Read on to understand more about it and find out its advantages and disadvantages before deciding if it is a strategy for you.
What is dollar cost averaging?
Dollar cost averaging is an investment strategy which investors can use when investing riskier investments such as stocks and mutual funds - which are more prone to market fluctuations. Dollar cost averaging is investing a fixed amount of money into a particular investment product on a regular basis, typically on a monthly or quarterly basis irrespective of the market situation - i.e. no matter if the market goes up or down.
When the market goes down, investors buy more shares at lower prices and when the market goes up, investors buy fewer shares at higher prices - which can effectively prevent a poorly timed lump sum investment when the market goes up. Dollar cost averaging works because it takes the emotional factors of investors out of the decision-making process when it comes to investing since investors are regularly making investments regardless of its price.
Whether or not it is suitable for you depends on your investment goal- both beginners and long-time investors can benefit from dollar cost average. If you prioritize preservation of assets than maximizing your investment returns, dollar cost averaging might be a better approach than lump sum investing.
Advantages of dollar cost averaging
Build the habit of regular investment
Dollar cost averaging requires investors to invest a fixed amount of money regularly into an investment product no matter what the market conditions are. This helps investors build a good habit of investing regularly which is useful to building wealth in the long run, and for compound interest to work.
Smooth out market timings
When it comes to investing, it is challenging, if not impossible to determine a market bottom. To avoid investing a lump sum of money at a bad timing, dollar cost averaging can lower the average amount investors spend on investments because you split your purchases and make multiple buys.
Remove emotions from the equation when investing
The more you are able to manage your emotion, the more likely you are to make better investments decisions. However, this is easier said than done. You may not want to take the risks to buy the dip - which is why many investors would prefer investing mechanically i.e. making use of dollar cost averaging to remove emotions from the equation when making investment decisions.
Disadvantages of dollar cost averaging
Lower investment returns in the long run
Dollar cost average strategy may result in a lower return compared to the lump sum investment strategy. The argument is that historically stock markets tend to rise over time and by prolonging the investment process, investors can miss out on positive returns when the market goes up in the long run anyway.
Dollar cost averaging does not always work
Investing regularly into a bad investment won’t turn it around. Instead, your losses could pile up if you continue investing in an investment product that keeps sliding downward.
Cash drag
With dollar cost average, you hold onto your money as cash longer, but not investing means your money can lose its original purchasing power over time due to inflation.
More investment costs
If you employ dollar-cost averaging, you might end up paying more brokerage fees - which could erode your returns.
Dollar Cost Averaging vs Lump Sum Investing
| Investment Strategy | Dollar Cost Averaging | Lump Sum Investing |
|---|---|---|
| Capital needed | Smaller | Larger |
| Risk level | Lower | Higher |
| Pros |
|
|
| Cons |
|
|
| Suitable for | Low risk tolerance and prefers laid-back investment style | High risk tolerance and able to handle the emotions when the market falls |
| Type of investment products it is suitable for | Volatile investment products | Less volatile investment products |
Points to note when adopting dollar cost averaging
Dollar cost averaging requires determination - you cannot let the current market situation fluctuate your position. You are required to put the same amount of money mechanically into the same investment product regularly despite the market situation because this strategy is designed to avoid buying at the top of the market.
Investors cannot blindly employ dollar cost averaging to all investments without personal due diligence. Dollar cost averaging into a bad investment won’t make a difference. Instead, you may end up piling up your losses.
If you use dollar-cost averaging, you may end up paying more brokerage fees as it involves more and frequent transactions - which could erode your returns. To mitigate this risk, you can consider buying passively-managed index funds with a lower fee.
FAQ
What does dollar cost averaging mean?
- It is an investment strategy which is designed to smooth out market timings. To achieve this, investors are required to buy a fixed amount of a specific investment on a regular basis no matter what the asset’s price is.
How can I apply dollar cost averaging to the crypto market?
- To apply the strategy to the crypto market, you can buy a specific amount of crypto currency regularly irrespective of the market condition.
Which investment strategy suits me more? Dollar cost averaging or lump sum strategy?
- It is important to note that there is no such thing as a perfect investment strategy. If you are low risk tolerance, dollar cost averaging is more suitable as it is designed to smooth out market timings. However, if you are the opposite, the lump sum investing is more suitable as it helps you earn more money quicker. Both are designed for long-term investment.