As financial experts warn about the threat of a recession due to the current COVID-19 pandemic disrupting the market, any investor will wonder what the best course of action is to avoid posting massive losses. That's where dollar-cost averaging comes in to play. Dollar-cost averaging is an investing strategy where people invest the same amount of money on a regular basis with a fixed amount. We briefly discussed using this method in a volatile market in this post. Below are six ways on how dollar-cost averaging reduces the impact of a volatile market:
1. Low-risk Option
Even when the market tanks, you can still earn stable returns by consistently investing in a low-risk fund. Instead of picking individual stocks, invest a set amount each month into low-risk options such as index funds and ETFs (exchange-traded funds).
These investment options are perfect for both the novice or conservative investors since they're both low-cost and diversified.
As an example, the S&P 500 is an index that holds stocks for the 500 largest companies in the U.S., including tech giants Apple and Google. Index funds also historically gain a steady rate of return.
Why? This is due to the fact that returns of an index fund are determined by the performance of the companies that are in it.
So, regardless of the underperformance of some companies, the others that are doing well will balance it out. Say you buy an index that contains two companies. One goes up by 4%, but the other goes down by 2%. So, therefore, you're still up by 2% overall.
2. Helps to Avoid Bad Market Timing
Bad timing can cost you dearly. Every now and then, both new investors and veteran wealth managers make these errors. Using dollar-cost averaging ensures that you won't sell low and buy high when the market is volatile.
It's especially beneficial during a market dip because while an average investor's reaction might be to halt or pull out investing until the market starts recovering to avoid a huge amount of loss, the better approach to get around it is to buy at the lower share price.
However, it's virtually impossible to time the market accurately over the long term, so dollar-cost averaging balances the odds so that investors come out ahead.
Investing a fixed amount into the stock market on a regular basis instead of buying a lump sum of stock all at once reduces risk because you're accumulating shares without trying to time the market yourself.
When the market tanks, inexperienced investors sell in fear and get a less than desirable return on their investment (usually at a loss too) because, by the time they sell, the market is already depleted of sellers. And, on the flip side, they buy when the market is nearing its peak. Being mindful of this critical phase by staying put will help you avoid this pitfall.
Editor's Note: It's impossible to time the market accurately because no one knows where the top or the bottom is. The point of dollar-cost averaging is that it prevents you from the pursuit of predicting where the market will be and shifts your focus on accumulating shares that will do well in the long run.
3. Can Result in Better Returns
When prices are falling, buy units at cheaper prices to reduce the average cost. And when periodic purchases are combined, the lower prices will reduce the average cost per unit of the overall investment.
Now more than ever, you'll want a diversified portfolio. Have your money invested in various types of assets, like stocks and bonds. Many stocks and funds pay dividends. Therefore, you can instruct your broker to reinvest those dividends automatically as you deem fit. That helps you continue to buy the stock and compound your gains over time.
4. Encourages "Think Long-term" Mentality
Regardless of the investment amount, dollar-cost averaging is a strategy that makes you buy and hold.
It is recommended that you retain your investments and wait out the volatile times to see the real value of dollar-cost averaging.
Over time, your portfolio will reflect both the premium prices and discounted prices. When share prices are high at the moment, you'd be able to purchase a few shares, but when it drops, you'd be able to buy more, and therefore the cost of the shares is averaged.
EN: Dollar-cost averaging encourages you to think long term because the costs get smoothed out as you continue to allocate money to your investment on a fixed schedule. And, as mentioned earlier, returns get better as you continue to amass more shares regardless of the price. This results in you detaching yourself from the short-term gyrations in the market, which don't matter in a multi-year investing timeframe.
5. Takes Emotion Out of the Equation
Stationary funds work well for most investors as they neither encourage fear nor greed. Consequently, doing the dollar-cost averaging strategy is advantageous in a bear market. This is because it allows you to acquire stocks at low share prices when most investors are too terrified or skeptical about doing so.
EN: Dollar-cost averaging makes the process mechanical, leaving the emotions out the door. When you commit a certain amount for a specified interval, you rid yourself of the unnecessary thinking that only clouds sound judgment with emotions.
6. Not Just for Stocks
This principle is not just applicable to stock trading. You can also use this strategy when investing in mutual funds and bonds.
A good example of this is an investment in a mutual fund, which has fluctuated in the market price per unit. Furthermore, if you think this technique is relatively new – it's not.
If you've been contributing to a 401(k) or a retirement account every month, you're already following this strategy and benefiting from it.
It helps to see the bear market as an opportunity rather than a threat. Nevertheless, make certain that you have enough emergency funds to cover at least three (six at a maximum) months' expenses. Investing is pointless if you can't keep up with your other monthly bills (and debt, if any).
Check out this post on how to maximize and extend your cash to make ends meet at times like these. Use the dollar-cost averaging strategy to stay calm during high-stress situations.
Remember, the goal is to position your portfolio for good returns when the market recovers.