Dollar-cost average: How it works & why it matters

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Quick thought I’d like to share:

 

Have you ever wondered why some advisors think investing incrementally over time is more of a punchline than sound advice?

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If so, you’re in good company. The decision of how and when to invest is difficult, and it’s further complicated by psychological factors.

 

While lump-sum investments are two-thirds more likely to have higher returns in bull markets than incremental investments (known as dollar-cost averaging or DCA), most people don’t have a lump sum to invest. Those sitting on a mountain of cash are typically windfall recipients—like those who receive a large bonus, inheritance, or win the lottery!

 

But the point here is that even though dollar-cost averaging is a clunky phrase and a questionable investment strategy, it is important to understand what it is and how it works. The reason why is because DCA brings serious benefits to the table for the average investor.

 

Before we further assess DCA’s usefulness, let’s first cover the what and the how of DCA. After we look at some examples, we’ll examine the pros and cons of a DCA strategy and explain how to start investing.

 

So let’s delve into the awkward world of DCA and see if we ever learn the punchline.

What is Dollar-Cost Averaging?

Instead of purchasing an asset all at once, DCA investors buy an asset over time and at regular intervals, no matter the market’s direction. The length of the interval and the investment amount is dependent on an investor’s specific strategy and budget.

 

Even though the pandemic inspired many people to change careers, it did not change the need to plan for retirement, and many retirement plans rely on gradual investment. For example, people who have a 401(k) are already using DCA by investing a portion of every paycheck.

 

In theory, the gradual accumulation of shares, coins, or similar assets allows investors to take advantage of volatility and the market’s inevitable ups and downs. Ideally, by using DCA, the average cost per share is reduced and the number of shares purchased is increased.

 

Dollar-cost averaging helps investors avoid buying assets when they are overpriced.

Since DCA works best in volatile markets, as was the case in the 1930s, it became the gold-standard savings strategy in the 1940s and is perhaps why the strategy is touted by today’s crypto enthusiasts. However, in 2012, Vanguard’s study showed investing a lump-sum into a portfolio based on MPT had higher profits more often than DCA.

How Does Dollar Cost Averaging Work, Exactly?

As the phrase suggests, DCA works by averaging the cost of an asset purchased over time and at different prices. Basically, you add the purchase prices together and divide the total by the number of purchases made. Let’s look at a simple example of when DCA is advantageous.

 

Imagine a crypto enthusiast had $10 to invest in dogecoin. Instead of investing all ten dollars at once, they invest $2.50 every week for four weeks. Following the table below, we’d find the average by adding up the numbers in the “Cost Per Coin” column and dividing that number by 4.

 

$0.34 / 4 = $0.85

Cost per coin

What if the crypto enthusiast had gone all in week one? They’d only have 100 coins. Spreading out their investment lowered the average cost and, in turn, allowed them to purchase more coins.

 

Thankfully the applications of DCA go beyond dogecoin, and if you’re hoping to stay ahead of the economic catastrophe caused by the shipping industry, dogecoin might not be the way to go. Other advantageous DCA investments include compounding dividends and, as mentioned, 401(k) plans. If you have a top broker for Roth IRAs, you are also likely already using a DCA strategy.

Is Dollar-Cost Averaging Worth It?

This is where DCA gets trickier. Traditionally, the time you spend in the market is far more important profits-wise than the exact timing of the investment. In other words, if you’re sitting on a pile of cash, invest it all now rather than incrementally.

 

However, while Vanguard’s paradigm-shifting study revealed the odds are in favor of the lump-sum investment, it doesn’t consider the investor or investing psychology. Finance journalist Dan Kadlec considers the investor in his Time article “Is Dollar-Cost Averaging Dumb?” He doesn’t say it directly, but he kind of implies we humans are the dumb ones.

 

Basically, we’re just primates trying to stay upright so we tend to see losses more threatening than we see gains as rewarding. In the end, Kadlec’s argument boils down to this: the stress-relief that comes from investing a windfall a little bit at a time is a benefit that outweighs the cost of underperformance.

 

In the words of C & C music factory, “things that make you go hmmm.”

 

So, is there ever a time when DCA is a suitable strategy for the risk-tolerant investor who has a lump sum to invest?

 

If you like the casino or enjoy risk as much as the former Wall Street Quants who struck it rich trading crypto options, using a gamified version of DCA might be your best strategy. In other words, buy the dips. Rather than squirreling away a bit of your paycheck into a diverse portfolio, only squirrel it into assets that are dipping.

 

Or just yolo it into doge. (Just kidding – please don’t do that.)

When DCA Outperforms Lump-Sum Investing

On a more serious note—and good news for the proletariat class—DCA did outperform the lump-sum investment on occasion. As Kadlec notes, the Vanguard study showed that ¼ of the time, “DCA with $1 million uotperformed the lump-sum approach by at least $43,000, and DCA beat the lump sum method by $200,000 in 5% of cases.”

We can get an idea of how DCA excelled by returning to our example. Since the odds are better for DCA in a falling market, let’s examine what would happen if the crypto enthusiast made regular investments of $2.50 during a month of downward-facing doge.

 

As the following table shows, after four weeks, the investor would have 141.96 coins with an average cost of $0.075.

 

Lump-Sum Investing table

If you’re thinking the crypto enthusiast is bonkers for believing the coin’s decreased value is an opportunity, you got to put on your long-term investment cap. Our fictional investor, like Elon Musk and Ethereum co-founder Charles Hoskinson, believes dogecoin’s floor needs a promotion. The investor has diamond hands and plans to hold ‘til kingdom come, but in the event they sold, let’s see how the profits would compare to a lump-sum investment.

 

Remember, the number of coins the investor purchased is contingent on their strategy and market direction. The following are the number of coins purchased with $10 in different scenarios:

  • DCA in Falling Market = 141.96 coins
  • DCA in Sideways Market = 119.73 coins
  • Lump-Sum = 100 coins

(Sell Price x Number of Coins) – Total Investment = Profit/Loss

 

Table

DCA in a falling market has the best profits, followed by DCA in a sideways market. The lump-sum investment is the least profitable. This is not to say investors should hope the price of their assets should nosedive so they can average down, although it could occur as uncertainty surrounding COVID and the Fed increases market volatility.

DCA in Falling and Rising Markets

If an asset tanks and never rebounds, investors will lose money. However, the example shows how DCA is a good strategy in bear markets. During the Great Recession, those who used DCA were able to take advantage of low prices, which meant they had higher returns when the market recovered.

 

Similarly, investors don’t want to only average up in a rising market. If an asset plummets after reaching its top, DCA might hurt an investor’s profits. Since the market tends to rise over time, lump-sum investments fare better than DCA.

Benefits and Limitations of Dollar-Cost Averaging

 

Pro and cons

We’ve seen how DCA is not all moon rockets and Shiba Inu puppies but can turn a profit on occasion, yet there are other benefits and limitations to consider.

 

Perhaps the most looming benefit is also the most costly. Even though DCA can help you eliminate the emotional factor from investing, making more small investments over time will incur more fees overall.

 

If you’re paying more fees to mitigate risk and make less money, hopefully you’re at least chillin’ with Snoop-Doge singing “Gin and Juice” with your mind on your money and your money on your mind.

 

Many also argue that relying on DCA lowers the risk of mistiming the market and spares people a visit from “Buyer’s Remorse’s” awkward cousin “Investor’s Remorse.” On the other hand, keeping cash on hand limits market exposure and might tempt the undisciplined to buy rather than invest.

 

After ten years of poorly managed DCA, an investor will have a family of Remorses camping in their living room and looking over their shoulder while they simply try to eat breakfast in peace. And that’s not an exaggeration.

 

If dogecoin hit a dollar before the crypto enthusiast invested their full ten-spot, they would end up howling at the moon instead of landing on it. In other words, they would have gotten a higher return had they invested the lump sum.

How to Start Investing with Dollar-Cost Averaging

Unless you’re a lucky windfall recipient, you’ll want to start a DCA plan as soon as possible. A good place to start is with fundamental analysis. Decide which stocks and/or ETFs you plan to invest in.

 

You’ll also want to know how much and how often you are able to invest. The amount should be roughly the same at each interval. The interval can be weekly, monthly, quarterly—or any other time frame that works for you.

 

Once these foundational decisions have been made, it is time to put your money into an account and start investing. If you have the DIY spirit and don’t want to set up automatic payments, remember to mark your calendar so you stick to your plan.

However, there are benefits other than taking emotion off the investment table when it comes to setting up an automatic payment plan. Let the computer do the work while you have fun roller skating and eating snow cones.

 

Unless your broker is a dinosaur, you’ll have an automatic payment option. But if your broker is a dinosaur, you might consider getting a modern broker with a great app that’s in the bronze age at least. Then again, maybe there are long-term benefits to using clams as currency.

How to Set up Automatic DCA

Thankfully, setting up automatic DCA is not like peddling a unicycle while juggling chainsaws. It is as easy as hitting a switch in the settings of an easy-to-use brokerage platform.

 

For example, on Robinhood, when you add money into your account, you’ll see a prompt asking if you’d like to make the transfer recurring. It is similar when you purchase a stock or a cryptocurrency.

 

To set up automatic dividend reinvestment, users will go to settings and to the heading “Investing.” If the dividend reinvestment option is “on”—awesome! You are already utilizing a DCA strategy. To switch on or off, simply click on the text. A drop-down menu will appear—that is where you can make your selection.

Robinhood interface

Although we don’t have the time to describe how this process looks on every other popular brokerage platform, it is always similar. All brokerages have a fairly simplistic way of turning DCA on and off, so setting up an automated purchase plan is not a hassle.

Dollar-Cost Averaging Tips All Investors Should Know

If you are like most people saving for retirement, using dollar-cost averaging is best used when done according to a plan that you stick to, such as setting up your account to compound dividends of blue-chip stocks. And it is best to start saving as soon as possible to ensure you get more money exposed to the market faster.

 

But if you have a lump sum to invest, there is just one very important point you should keep in mind: Don’t wait for the perfect opportunity to buy low. First of all, there is no safe way to know when this moment will come or to even recognize it when it comes—it’s usually better to buy in early and avoid missing out on potential gains. Time in the market beats a golden buying opportunity.

Conclusion

Whether you made it this far because you were riveted by DCA or because you were awaiting the punchline, kudos to you. Retirement plans and windfalls are important financial matters but not easy topics to talk about.

Now, next time someone asks you if dollar-cost averaging is a punchline or sound advice, you can explain that it’s only a punchline for people sitting on a pile of cash, and they aren’t laughing.

Dollar Cost Averaging: FAQs

  • Does Dollar-Cost Averaging Really Work?

    Yes, dollar-cost averaging works but primarily in bear markets that eventually turn around. Investing over time, rather than all at once, can sometimes result in higher returns.

  • Is it Better to Dollar-Cost Average or Invest a Lump Sum?

    If you have a lump sum, it is best to invest it all at once into a diversified portfolio. Lump-sum investments tend to outperform incremental investments over time. Dollar averaging, however, might be best for windfall recipients in bereavement or in money shock.

  • Does Warren Buffet Dollar Cost Average?

    The chances that Warren Buffet uses a DCA strategy, such as compounding dividends, are pretty good. He has been known for praising the strategy, especially during heightened volatility and with exchange-traded funds.

  • Is it Better to Dollar-Cost Average Weekly or Monthly?

    It is better to dollar cost average on a schedule that works for you and with a frequency you can afford. Investing weekly can get your money market exposure more quickly than investing monthly, but it might result in more broker fees.

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This article originally appeared on Tokenist.com and was syndicated by MediaFeed.org.

 

The risks of playing the stock market

 

To the uninitiated, the stock exchange can seem like a casino, with news and social media feeds sharing stories of investors striking it rich by playing the stock market. But while there are winners, there are also losers, those who lose money playing the market, sometimes pulling their money out of the market because they’re afraid of the potential of losing money.

Playing the stock market does come with investment risks. For new investors learning how to play, the stock market can be a frustrating, humbling and in some cases, incredibly rewarding experience.

While investing is serious business, playing the stock market does have an element of fun to it. Investors who do their research and tune into the news and business cycles can take advantage of trends that might better enable them to earn good returns on investment.

This is what you need to know about how to play the stock market, the risks involved and what makes the market so alluring.

Related: Investment education for beginners

 

Andrii Yalanskyi // istockphoto

 

Despite the phrase “playing” the stock market, it’s important to make the distinction between investing and gambling up front.

While there are some clear similarities — both investors and gamblers are trying to make money, after all — there are a couple of key differences. While both gambling and investing involve risk, investing actively manages that risk, rather than relying on blind luck to guide a person to positive returns. Second, and similarly, investing involves a strategy, something that a gambler pulling the lever on a slot machine or betting on red or black can’t employ.

But because all investing involves an element of risk — there is no 100% safe investment — in a way each investment can feel like a gamble. However, it’s important to keep in mind that the market is not a casino, and just because there’s risk involved doesn’t mean that “playing the market” is the same as playing roulette.

So what does “playing the stock market” actually mean? In short, it means that someone has gained access to and is actively participating in the markets. That may mean purchasing shares of a hot new IPO, or buying a stock simply because Warren Buffett did. “Playing,” in this sense, means that someone is investing money in stocks.

 

g-stockstudio/istockphoto

 

Learning how to play the stock market — in other words, become a good investor — takes time and patience. It’s good to know what, exactly, the market could throw at you, and that means knowing the basics of the risks and rewards of playing the market.

 

 

g-stockstudio/istockphoto

 

In a broad sense, the most obvious risk of playing the market is that an investor will lose their investment. But on a more granular level, investors face a number of different types of risks, especially when it comes to stocks. These include market risk, liquidity risk, and business risks, which can manifest in a variety of ways in the real world.

A disappointing earnings report can crater a stock’s value, for instance. Or a national emergency, like a viral pandemic, can affect the market at large, causing an investor’s portfolio to deflate. Investors are also at the mercy of inflation — and stagflation, too.

For some investors, there’s also the risk of playing a bit too safe — that is, they’re not taking enough risk with their investing decisions, and as such, miss out on potential gains.

 

g-stockstudio/istockphoto

 

Risks reap rewards, as the old trope goes. And generally speaking, the more risk one assumes, the bigger the potential for rewards, though there is no guarantee. But playing the market with a sound strategy and proper risk mitigation tends to earn investors money over time.

Investors can earn returns in a couple of different ways:

  • By seeing the value of their investment increase: The value of individual stocks rise and fall depending on a multitude of factors, but the market overall tends to rise over time and has fully recovered from every single downturn it’s ever experienced.
  • By earning dividend income: Dividends can also be reinvested in order to further grow your investments.
  • By leaving their money in the market: It’s worth mentioning that the longer an investor keeps their money in the market, the bigger the potential rewards of investing are.

 

g-stockstudio / istockphoto

 

Nobody wants to start investing only to lose money or otherwise see their portfolio’s value fall right off the bat. Here are a few tips regarding how to play the stock market, that can help reduce risk.

 

StockRocket / istockphoto

 

The market tends to go up with time and has recovered from every previous dip and drop. For investors, that means that simply keeping their money in the market is a solid strategy to mitigate the risks of short-term market drops.

That’s not to say that the market couldn’t experience a catastrophic fall at some point in the future and never recover. But it is to say that history is on the investors’ side.

Consider: If an investor buys stocks today, and the market falls tomorrow, they risk losing a portion of their investment by selling it at the decreased price. But if the investor commits to a buy-and-hold strategy — they don’t sell the investment in the short-term, and instead wait for its value to recover — they effectively mitigate the risks of short-term market dips.

 

Tzido/ istockphoto

 

It’s always smart for an investor to do their homework and evaluate a stock before they buy. While a gambler can’t use any data or analysis to predict what a slot machine is going to do on the next pull of the lever, investors can look at a company’s performance and reports to try and get a sense of how strong (or weak) a potential investment could be.

Understanding stock performance can be an intensive process. Some investors can find themselves elbow-deep in technical analysis, poring over charts and graphs to predict a stock’s next moves.

But many investors are looking to merely do their due diligence by trying to make sure that a company is profitable, has a plan to remain profitable, and that its shares could increase in value over time.

 

Pinkypills / istockphoto

 

Another effective risk-mitigation strategy that investors can employ is diversification. Diversification basically means that an investor isn’t putting all of their eggs into one basket.

For example, they might not want their portfolio to comprise only two airline stocks, because if something were to happen that stalls air travel around the world, their portfolio would likely be heavily affected.

But if they instead invested in five different stocks across a number of different industries, their portfolio might still take a hit if air travel plummets, but not nearly as severely as if its holdings were concentrated in the travel sector.

 

Lazy_Bear / istockphoto

 

Dollar-cost averaging can also be a wise strategy. Essentially, it means making a series of small investments over time, rather than one lump-sum investment.

Since an investor is now buying at a number of different price points (some may be high, some low), the average purchase price smooths out potential risks from price swings.

Conversely, an investor that buys at a single price-point will have their performance tied to that single price.

 

NicoElNino / istockphoto

 

While playing the market may be thrilling and potentially lucrative, it is risky. But investors who have done their homework and who are entering the market with a sound strategy can blunt those risks to a degree.

By researching stocks ahead of time and employing risk-reducing strategies like dollar-cost averaging and diversification when building a portfolio, an investor is more likely to be effective at mitigating risk.

Learn more:

This article
originally appeared on 
SoFi.com and was
syndicated by
MediaFeed.org.

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