What is Dollar-Cost Averaging?
Investing could seem challenging. Even seasoned players who attempt to time the market to be able to buy at the right time end up making mistakes.
Dollar-cost averaging refers to a strategy that could make it simpler to work in uncertain markets with the help of automatic purchases. It also assists an investor’s online investment efforts on a regular basis.
Dollar-cost averaging includes investing a set sum of money in a target security consistently on certain intervals over a course of time irrespective of the price. With the help of dollar-cost averaging, investors would have to bring down their average cost per share to cut down the effect of volatility on their portfolios.
This strategy essentially takes out of the picture the effort needed to try and time the market in order to get the best buy price. Dollar-cost averaging is also referred to as the constant dollar plan.
How Dollar-Cost Averaging works
Dollar-cost averaging refers to a simple tool that can be used by an investor to save and create wealth in the long term. It is yet another way an investor could let go of the short-term volatility in the broad markets.
Dollar-cost averaging is among the finest strategies that amateur traders looking to trade ETFs could use. In addition to this, several dividend reinvestment plans help investors to the dollar-cost average so they can purchase on a regular basis.
Dollar-cost averaging could even be helpful in buying mutual or index funds regularly either in another tax-advantaged account like a traditional IRA or a taxable brokerage account.
Benefits of Dollar-Cost Averaging
1. Risk reduction
Dollar-cost averaging brings down the investment risk, and capital is saved to remain protected from a crashing market. It saves money, which helps in providing liquidity as well as flexibility in managing an investment portfolio.
DCA dodges the disadvantages which follow lump-sum investing by buying a security when the rates are high because of market sentiment and it leads to the purchase of a lower-than-necessary quantity of a security. As the security price meets its inherent rate with the help of market correction, the investor’s portfolio would register a loss.
A few downturns could be prolonged, which may further bring down the portfolio’s net worth. Using DCA makes sure that the loss is reduced while the gains remain high.
2. Lower cost
The purchase of market securities when the rates begin to fall makes sure that the investor gets large returns. With the help of the DCA strategy you could be sure about buying more securities than you would have been able to buy should the prices be high.
3. Ride out market downturns
When you use the DCA strategy by investing small amounts from time to time, you help in ruling out market downfalls. The portfolio which uses DCA could maintain a proper balance and keep the potential of the portfolio’s value to rise in the long term.
4. Disciplined saving
The strategy of adding funds from time to time to an investment account makes disciplined saving possible since the portfolio balance rises despite a depreciation in its current assets.
5. Prevents bad timing
Market timing is not something that can be easily mastered even by the leading investors. Investing a huge amount when the timing is not right could be very risky, which could negatively affect a portfolio’s value. It is hard to predict market swings and this is why dollar-cost averaging strategy helps in easing out the purchase cost that could help the investor.
6. Manage emotional investing
Emotional investing could happen because of several factors like depositing a huge amount at once and being very averse to loss. Using DCA could help in getting rid of emotional investing.
A disciplined buying strategy using DCA could help the investors concentrate their energy on the task at hand and get rid of news as well as information hype that would stem from different media with respect to the stock market’s short-term performance as well as direction.
Drawbacks of Dollar-Cost Averaging
There is enough evidence which proves that DCA could help in bringing down the average dollar cost when used in a disciplined manner as well as when the market conditions are positive. But there are also many other studies that dispute the advantages:
1. Higher transaction costs
When you systematically buy securities in small amounts over a course of time, investors may have to deal with increased transaction costs, that could have the capacity to offset the gains that the present portfolio assets have accrued.
But it would mostly rely on the kind of investment strategy in use. Like how certain mutual funds have a high expense ratio that could have an impact on the portfolio’s value in the medium- to long-term run.
2. Asset allocation priority
DCA critics are of the opinion that an investment strategy needs to emphasize on the required asset allocation in order to mitigate risk. Following a DCA could make the uncertain nature much worse since the target asset allocation parameters would need more time to be met. The economic, as well as physical environments, could change over the course of time which is why investors must be able to flexibly realign their portfolios in order to keep them safe from losses and make the most of new opportunities.
But for an investor following DCA, the opportunity may be hard to take advantage of. It is wise on the part of investors to keep their funds in a money market investment account which gets interest while it awaits proper allocation in other strategic assets by best cfd broker.
3. Low expected returns
The risk and return theory has some straightforward dynamics– high risk brings high returns while low risk brings low returns. Therefore, to be in line with a DCA strategy to cut down risk would inevitably bring low returns. The market generally undergoes longer bull markets where the prices increase. Hence, a DCA investor has better chances of losing out on asset appreciation as well as higher gains as compared to investing a lump sum at once.
