Why Dollar Cost Averaging Is Important For Investors
Investing is an important part of your financial plan. But investing looks different for each person. Your investment strategy relies on many factors including your goals, risk tolerance, timeline, and mindset.
Here at TFS, it is our goal to guide you through the investing practices and decisions that make the most sense for you and your financial goals. One strategy we like to use is called dollar-cost averaging (DCA).
Dollar-cost averaging is an investing strategy that allows the investor to control the purchases of a particular asset over a fixed period of time. This strategy is an excellent way for investors to make significant long-term impacts while also combatting short-term volatility. If you are contributing to a 401(k) with regular payroll deductions, you are already making use of this strategy. So what is DCA and how can it work for you? Let’s find out!
What is DCA?
Dollar-cost averaging is an approach used by investors to invest over time. When employing a DCA strategy, the investor divides the total amount that they want to invest in a targeted asset across fixed, periodic purchases.
By spreading purchases across a fixed period of time, the investor is able to purchase their targeted asset over a few months/years, etc. without paying for it all upfront. Avoiding a lump sum payment model may help lessen market volatility and an investor’s aim to “time” the market in conjunction with a large purchase.
But that isn’t always the case. Lump-sum contributions can be extremely beneficial and often outperform its dollar-cost averaging counterpart. It is really about examining and balancing the resources you have available and the goals you have as an investor.
Using DCA, the investor will purchase more shares of the asset when the price is lower and less when the price is higher, therefore potentially averaging a lower cost per share than if it were paid in a lump sum. Let’s look at an example:
Deb has $400 to invest in Company X. She spreads her purchases over 4 months. In month 1 the price per share is $40 so she purchases 2 shares. The second month the price drops to $30 so she purchases 4. The remaining 2 months the price stays at $20 so she purchases 5 each of those 2 months. Over those 4 months, Deb bought 16 shares at an average price of $27.50 per share. If she bought them all upfront she would only have been able to purchase 10 shares at $40. Using DCA, Deb was able to purchase more shares for a better average price.
DCA and market downturns
Many investors use dollar-cost averaging regardless of market trends, but it can also be smart to consider how this strategy works when the market is going down.
When the market decreases in value, assets lose some of their value as well, making the price per share decrease. Sometimes, this reduction can allow investors to purchase otherwise expensive assets at more affordable share prices. If you start contributing when the market is down, you will have the chance for more opportunities and diversity in the assets you purchase and those shares will likely also increase in value as the market goes up again.
It is important, however, to recognize and understand the risks and technical challenges associated with it.
- Lack of liquidity
- If too much of your money is tied up in assets that aren’t liquid, it could be difficult to use that money quickly. It is important to look at the liquidity levels of your assets and ensuring you do have funds you can use should you need to.
- Retirement timeline
- Investing when the market is down can be a useful strategy for many investors but you need to keep your own goals and timeline in-sight as you embark on your investing adventures. If retirement is on the horizon (about 5 years out or so) it might be best to be more conservative so as not to risk the funds you have worked so hard to save. Know your retirement timeline and your risk tolerance in light of that.
- Long term vs short term impact
- DCA is used to potentially increase long term returns while attempting to reduce short term volatility. Think through how you are using DCA and if it makes sense with your investing goals.
If you are interested in investing when the market is down, you need to be proactive about your strategy and subsequent purchases as the average downturn is approximately ¼ of the time of the average “upswing.”
DCA is just one strategy in the grand scheme of your overall portfolio. Here at TFS, we take the time to rebalance your portfolio each quarter to help things move in the right direction. We would be happy to talk with you more about what this means for you and your investments.
Dollar-Cost Averaging does not guarantee a profit or protect against losses in a declining market. Investing always involves risk including the potential loss of principal.
Your goals matter most
DCA can be a sound investing strategy depending on the goals you have and your risk tolerance. As you prepare for retirement take some time to evaluate how your investing goals may have changed.
- What are the top benefits you hope to receive from investing?
- In what ways do your short term and long term goals work together?
- How do you see your involvement in the market changing as you near retirement?
- What does investing in retirement look like to you?
- How can your investments best reflect the goals you have for your future?
Understanding your long-term goals for investing will give you an idea of the role you see investing playing in retirement. More and more, people are interested in investing in retirement. It is important, then, to think about how long you want to be in the market and what your goals are.
Keeping your goals in mind is essential as you continue to invest. Both your short-term and your long-term goals matter as you develop and alter your investing strategy. Be sure you talk with your financial advisor to see how your strategy can best reflect the goals and objectives you have for the future. We would love to speak with you about dollar-cost averaging and see if it is the right fit for your investment strategy.