What is the one dream most people have in common at some point in their lives? Becoming rich without having to do much seems like one of the top candidates, wouldn’t you agree?
While it’s highly unlikely you will stumble across immense wealth at any time in your life without having to do much more than the actual stumbling – investing your money comes pretty close. Sure, you’ll have to put in some work, whether it’s research and managing or earning the necessary funds in the first place. Nor will you immediately see huge returns. In fact, it’s highly likely that investing will never actually make you rich. But it certainly can make you very comfortable and maybe even allow you to retire earlier or quit your day job entirely.
Money generates money. But not all of us can afford to put up large lumps of cash to invest. Especially if you’re a beginner investor, investing lump sums may feel like unnecessary risk that you’d like to avoid. That’s where dollar cost averaging as an investment method rushes in to save the day.
How does it work?
Dollar cost averaging (DCA) is an investment strategy where you – the investor – invest fixed sums of money over a period of time in order to reduce the impact of market volatility of the asset in question. The DCA principle is heavily employed when investing in long term mutual funds or 401(k) plans (in the US). In both cases, you make set-amount investments at fixed intervals over the long-term, regardless of the asset price. It can be used for more volatile assets, like stocks, but requires additional expertise to be as effective.
For example, you have allocated €1 200 for investing, but have some reservations whether it’s safe to invest the lump amount at once. By using the DCA method, you can divide the lump sum in smaller increments and invest them at fixed intervals over a period of time – like €100 per month over the period of a year.
In essence, this investment strategy helps you avoid the stressful and responsible process of timing the market in order to make a value investment. The key is to always buy at your previously set intervals, regardless of the asset price. Since assets, like stocks or exchange-traded funds (ETFs), can sometimes be volatile – you may not always succeed in purchasing at lower cost. However, DCA has the potential to reduce the average cost basis of your investment, as over a longer period of time the asset price might fluctuate in both directions. But if the value only goes up – you still win.
It’s important to note, however, that the DCA method should be used only if the asset in question continues to rise in value over time. Small, occasional dips are necessary for this method to be more effective, but abandon sinking assets. Similar to most other investment strategies, DCA will not protect you from continuously declining asset value or a market crash.
Is DCA worth it?
This method is considered to be one of the most basic investment strategies. For that reason alone, it can be deemed as “worth it”. Especially when you’re still a novice investor, using DCA will relieve you of some potential errors you would be susceptible to as a beginner.
For someone who is just starting, this method can help establish better saving and investing habits, as you have to follow a certain schedule, and you mustn’t panic-sell for DCA to make sense. If you don’t have an amount of money already put aside for investing, this method is much more accessible as it allows for smaller payments that have to be made over time.
If you’re a beginner investor, and you decide to try the DCA method, you might find it’s better using this method with mutual funds (like index funds or ETFs, for example). The diversity of an index fund helps you reduce the overall unsystematic risk of the investment, therefore limiting the potential for loss-of-capital. Dollar cost averaging single stocks could be a bit more risky, more so when you don’t yet have the experience and/or the knowledge. That in turn can lead to panicking at first signs of value dip.
With how easy it’s become to invest these days, the average investor is more likely to be a beginner rather than an experienced one. Yet, even if you have experience, using the DCA method can make sense for your passive investments. For example, you already invest in index funds or ETFs wherein the diversity of these assets can help protect your investment against unsystematic risks. With DCA, you’re also protecting yourself from self-imposed risks, like unnecessary panic-selling or buying assets at perceived lows or highs, respectively.
Using DCA will not extinguish the risk of declining value. Therefore, in the case of less diverse-more volatile assets, like stocks, due diligence must be performed regularly.
A sure-fire method to get you started
In conclusion, the worthiness of the DCA method is well renowned. It is still considered one of the best methods to help you get on with your investments. It will both teach you proper investing habits as well as potentially bringing in higher returns by lowering your investment’s average cost basis. And, in reality, if you’re already making regular payments towards a retirement or pension fund, you’re employing the DCA method.
In the short term, DCA may not be as profitable as other investment strategies (an example would be value investing) – since you invest in assets regardless of price. Yet, if your risk tolerance prohibits you from making lump sum investments, the return on other methods would still be limited in a way. And, long-term, the DCA strategy has the potential to lower the average asset value, thus giving you increased returns on your cheaper investments and mitigating losses on the more expensive.
Is this the best method for the average investor? Considering the average investor nowadays is closer to a beginner than an expert – an argument can certainly be made. Over time, this method has the capability to help you grow your wealth from the bottom up, as it doesn’t require you to already possess a significant amount of riches. And if you already have investing experience as well as additional resources, the DCA can still help you easily add diversity to your overall investment portfolio.