Oh go on, one more investment related step before we end the series on investing… Despite its very boring name, dollar cost averaging is a powerful investment strategy that actually makes market volatility work in your advantage.
This is achieved in two ways:
- When the market is up you buy less shares, thereby avoiding investing a lot of money when shares are overpriced and when a crash might be just around the corner;
- When the market is down, you benefit by buying more shares, thereby making the most of the shares being “on sale”.
Let’s look at how dollar cost averaging works.There are generally two ways to invest: investing a lump sum or investing a set monthly amount. As we know markets go up and downs all the time and although most markets go up over time, they still experience periods when prices drop.
Lump sum investing
Imagine you have a windfall of say $10,000 that you want to invest. If you invest it all in one go at a time when the market is climbing, this might be a very poor moment to invest this money. Wait a few months and the market might well experience a downturn:
- Say the average price of shares at the moment is $100 then (costs excluding) you’d get 100 shares for your $10,000.
- Imagine the prices drop to $80 on average in the next 6 months. If you had held off investing for 6 months, you would have been able to buy 125 shares, i.e. 25% more!
- Now let’s say that another 6 months later the price of shares is back up to $100 a share again. If you entered the market today, you would have gained nor lost anything in a year’s time. Had you entered the market when shares were only $80 a piece, your portfolio would be worth $12,500 in a year’s time.
The problem with the above is that timing the market is almost impossible. Nobody – bar just a handful of exceptional investing experts – can really predict what the market will do. It’s nearly impossible to predict market crashes, and even during a bear market it is very difficult to predict when the lowest point has arrived. In the above example, nobody can tell you whether the price of $80 was its lowest point, or whether to wait another few months for the price to go down to $60.
Added to this is again the psychological component of human behaviour that comes into play when investing: fear often stops people from investing when markets are dropping, throwing $10,000 at the market when prices go down every single day requires a lot of stomach. And not stepping in when markets are on a high and prices are rising every day is equally difficult, especially when you hear many others boasting about their results and convincing you that now is the time to join.
If you try to only invest when the market is low, you have the additional problem that you never know how long you end up waiting. If there’s a bull market that lasts a good 3 years, then all that time your $10,000 is sitting idly, losing value due to inflation instead of making the most of the effect of time on your portfolio you could have used if you had invested that money from the very beginning.
Dollar Cost Averaging
Enter dollar cost averaging, a strategy in which you don’t try to time the market, yet still buy more shares when prices are low and less shares when prices are high. How do you do this without having to follow the market continuously? By investing a set amount monthly.
- Let’s say this monthly amount that you invest is $300. If at the moment prices are $100 per share, you buy 3 shares every month.
- When prices go up (because everybody is buying like crazy and pouring lots of money into the market, you don’t follow the hype and buy more, as you know prices will come down again and that a sale might be coming up at some point. So when prices go up to $150 you only buy 2 shares (you are after all still investing $300 a month).
- When the opposite happens and prices drop to $75 a share, your steady investment strategy now buys you 4 shares, thereby profiting from the cheap share prices to buy some extra.
That is the essence of dollar cost averaging, simple yet effective. And the added beauty is that it takes away the human factors of greed and fear when prices are rising or dropping respectively. It ensures you keep your cool and stick to your plan without getting distracted and without having to worry about when to step in.
Step 96 – Dollar Cost Averaging – in detail:
- Look at your budget and determine the monthly amount you can and feel comfortable investing.
- Set up an automatic payment into your investment account.
- Know that when prices fall or rise, you will still be investing the same amount every single time. Don’t deviate from this, just stick with your monthly amount.
- Follow along and see how you end up with more shares every time the market drops and less shares when prices rise.
When following a dollar cost averaging strategy, even though you don’t time the market and still purchase when prices are high, overall you ensure that you benefit from the ups and downs of the marketby buying more when shares are on sale and less when the prices are too high.
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.