There is an investment strategy that allows investors to minimize the impact of market volatility and maximize the potential of their investments. It is called dollar-cost averaging. Popular financial analyst Benjamin Graham invented the term and discussed it in his 1949 book “The Intelligent Investor” in which he promoted and discussed the principles of value investing. The term is sometimes referred to as pound-cost averaging in the United Kingdom. Some prefer using the terms unit-cost averaging, incremental trading, or the cost average effect. It soon became one of the more endearing concepts taught in personal finance and in specific long-term or buy-and-hold investment goals and objectives. What exactly is dollar-cost averaging? How does it work? What are the advantages or benefits and disadvantages or risks?
Should You Use Dollar-Cost Averaging: Understanding the Principles and Explaining Its Advantages and Disadvantages
Dollar-cost averaging involves investing a fixed amount of money into a specific investment at regular intervals regardless of the cost or price. This investment can be a stock of a particular company or a pooled fund like an exchange-traded fund or mutual fund. The purpose of this approach to investing is to reduce the impact of market volatility or regular price movements, lessen market timing risk, and build a disciplined investing habit.
Note that regularly allocating a fixed amount of money for a specific investment would reduce the average cost of the investment. For example, when it comes to investing in a particular stock, remember that its price is not fixed. There are times when its stock price is high and there are times when it is low. Regularly buying shares of this stock at fixed intervals leads to more shares being purchased when the price is low and fewer when the stock price is high.
The opposite of dollar-cost averaging is a one-time lump sum investment. Investing a huge amount of money in a single transaction or all at once exposes an investor to the risk of market timing. The cost or price of the investment could be high and he or she would be using all of his or her money in a single transaction. Furthermore, when an investor invests a lump sum before a market downturn, he or she could lose the value of the investment immediately.
On the other hand, through a dollar-cost averaging strategy, this investor would invest a small and fixed amount of money either monthly or quarterly. The total investment cost would be less than a one-time lump sum investment because the highs and lows of the investment would average over time. However, in some instances, this might not be an optimal solution. A lump sum investment based on optimal marketing timing can be a more beneficial strategy.
Pros: Dollar-Cost Averaging Advantages and Benefits
1. Reduces Impact of Market Volatility
Investing a fixed amount at regular intervals can help lessen and smooth out the effects of market volatility. An investor can end up buying more shares or units when prices are low and fewer shares or units when their prices are high. This lowers the average cost of investment over time.
2. Lessens the Risk of Market Timing
Another advantage of dollar-cost averaging is that it saves investors from the pitfalls of having to guess when market prices are high or low. Remember that investing regularly at various price points has the potential to average out the cost per share or unit over time.
3. Removes Emotions from Investing
This strategy also factors out emotions in investing decisions. Take note that trying to time the market can result in investors making impulsive decisions and irrational choices based on fear or greed. A dollar-cost averaging strategy is a systematic approach to investing.
4. Promotes Disciplined Investing
Investors that have embraced this strategy are essentially building a disciplined investing habit. To be specific, because it involves a recurring investment of a fixed amount of money, investing can be treated similarly to bills. It is also suitable with a direct stock purchase plan.
5. Makes Investing More Accessible
Another advantage of dollar-cost averaging is that it allows an individual to invest with smaller amounts of money. There is no need to save up to afford a one-time lump sum investment. This is also ideal for affordable stocks like fractional shares, penny stocks or ETFs and MFs.
Cons: Dollar-Cost Averaging Disadvantages and Risks
1. Has a Lower Return Potential
There are stocks and other securities that tend to trend upward over the long term. The stock market and specific stock indices tend to have historically trended upward. This means that investors are more prone to incurring increasing investment costs and higher average costs.
2. Lengthier Wealth Accumulation
Another disadvantage of dollar-cost averaging is that it is positioned for long-term investing. Remember that it involves buying shares or units over time. It would take longer for these shares or units to substantially accumulate. This makes it ideal for younger investors.
3. Less Effective in Rising Markets
Dollar-cost averaging is also considered in emerging markets or in securities that have immediate growth potentials like promising small-cap and mid-cap stocks. This investment strategy is more aligned with the principles of value investing and less with growth investing.
4. Benefits of Lump Sum Investing
There are benefits to a one-time lump sum market-timed investment. For example, when the price of a stock is low due to a short-lived downturn or because it is an emerging company, a one-time investment of a larger amount of money means capturing future substantial gains.
5. Does Not Guarantee Success
Another disadvantage of dollar-cost averaging is that it is not a fool-proof investment strategy. It has the potential for higher costs due to more frequent transaction fees that can add up over time. It also does not guarantee protection against losses in declining securities or markets.
