“Buy low and sell high” is the classic mantra when it comes to investing. But how exactly does a person know when the market is at an actual low point?
It’s easy to look at a graph of historical stock prices and think about all of the money you could have made “if only you had invested at the bottom.” Easier said than done! The problem is that in real-time no one really knows when the bottom is happening.
However, that doesn’t stop some investors from trying. There is no shortage of traders on YouTube and other social media channels who claim that they can predict potential buying opportunities. Yet, studies have shown that they tend to only be right about 10 percent of the time.
This is why a better approach to investing is to keep things as simple as possible and to use an alternate strategy called dollar-cost averaging. In this post, we’ll explain what dollar-cost averaging is, its benefits, and share some data on why it works.
What Is Dollar-Cost Averaging?
Dollar-cost averaging (DCA) is when a person periodically invests money at regular intervals over a long period of time. This is typically done regardless of price or market conditions. No matter if the markets are trading high or low, the investor will pre-schedule the automatic purchase of the desired securities (i.e., once per month, week, etc.) and continue this cycle into the foreseeable future.
How Does Dollar Cost Averaging Work?
Let’s say you’ve got $12,000 to invest. You essentially have two choices:
- Invest the full $12,000 today
- Buy shares little by little at $1,000 for the next 12 months
With the first option, there’s a huge potential for both risk and reward. You might invest the $12,000 today and watch it double to $24,000 after a year. But you also have the possibility that it might drop in value by half to $6,000. Even though the hope is that the market will go up, there’s really no telling if “today” is a low point and a good time to buy.
If you went with the second option, then your risk is spread out. Naturally, investment prices will fluctuate going up and down throughout the year, and so you might buy when prices are higher or lower than normal. However, because you’re taking advantage of these price changes, there’s a better chance you’ll have invested during low points and bought at a discount.
DCA Example – A 401k plan
A good example of dollar cost averaging is when people saving for retirement use a 401k plan. By design, 401k participants automatically contribute to their accounts when they get paid – every two weeks for most U.S. workers. This helps them to invest consistently and without emotion adding to their portfolios no matter how the market is doing.
What are the Advantages of DCA?
For most investors, dollar-cost averaging is a good strategy because of the following reasons:
Anyone can use dollar-cost averaging. Even complete beginners who have never invested before can pre-schedule contributions and automate future purchases.
2. It Eliminates GuessWork
Even when day traders use candlestick charts (i.e., the graphs will all of the red and green rectangles on them) to analyze an investment, they’re still only guessing at what will happen next based on trends and history.
Because dollar cost averaging doesn’t care what will happen next, there are no predictions or complex analyses to be made.
3. Takes Advantage of Market Volatility
When shares are bought in regular intervals, it increases the chances that you’ll buy during (or as close to) a market low point. By contrast, investors who wait for the right time to buy shares may never do so because those low points may never come (… more on this below).
4. It Removes Emotion
As you might guess, people who day trade and have to make judgments about if now is the right time have a lot riding on their shoulders. That can cause a lot of emotional stress. It may even cause them to freeze up when the opportunities are clearly good!
Dollar-cost averaging, on the other hand, is automatic. Investors don’t look at how the market is doing. They just “set it and forget it” and let the market take them where it will.
Timing the Market vs Dollar Cost Averaging
Let’s imagine for a second that you have the incredible power to know ahead of time exactly when the market will bottom out. Seems like a no-brainer that you’d be able to beat dollar cost averaging, right?
Surprisingly, no. A few years ago, financial analyst Nick Maggiulli published a very interesting blog post where he compared exactly these two scenarios. And what he discovered was that even with perfect information a simple DCA strategy still comes out ahead almost every time.
How? As it turns out, when an investor tries to time the market, it’s exactly this instance of “timing” a dip that works against them. To illustrate this point, consider someone from the 1970s who might have bought when the market dipped back in 1974. If they held out and waited until the next dip, then they wouldn’t have invested again until 1985. That means they would have missed out on ten years’ worth of potential buying opportunities!
Maggilulli’s conclusion: If you attempt to build up cash and buy at the next bottom, you will likely be worse off than if you had bought every month. Why? Because while you wait for the next dip, the market is likely to keep rising and leave you behind.
In other words, those who stuck by a simple DCA strategy capitalized on good-old compound growth and saw their portfolios flourish.
Why You Should Use Dollar-Cost Averaging
For the common investor, the best course of action would be to steer clear of trying to time the market and use a hassle-free approach like dollar cost averaging. As we’ve shown, not only will it be easy to implement and fully automated, but it has a high probability to beat even those experienced traders who are trying to guess at what price a security will trade at tomorrow.
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