People like to put money in their bank accounts because they trust it will be there when they need it—even if its buying power has been eaten away by inflation. Investing, on the other hand, involves risk. It involves volatility. And even though the markets tend to trend upward over the long term, in the short term there can be dramatic movements in either direction.
Does this mean risk-averse individuals who are uncomfortable with volatility shouldn’t invest? Absolutely not. In fact, there’s a particular style of investing such individuals can employ to reduce the overall volatility of their investments: Dollar-cost averaging.
What is dollar-cost averaging?
Dollar-cost averaging (DCA) is an investment strategy where an individual invests the same amount of money on a regular, recurring schedule—instead of an aggregate lump-sum all at once.
Whether you’re investing daily, weekly, or monthly, dollar-cost averaging allows you to spread out your investments, buying more shares of an asset when prices are lower, and fewer shares of an asset when prices are higher. Over time, this helps to make you less susceptible to wild price swings by flattening the peaks and raising the valleys of your average purchase price.
For example, consider that you have $1,200 that you’re looking to invest into an ETF. If you were to engage in dollar-cost averaging, you might decide to invest $100 per month over the course of a year. In this hypothetical scenario, the following table illustrates how many shares you were able to buy at any particular time:
Dollar-Cost Averaging Example
By the end of the year, you’ll have bought 258.24 shares of the ETF for an average cost (weighted by the number of shares) of $4.64. This means that despite all the volatility, you’ll actually have ended on a modestly positive note for the year, even though you bought shares for north of $5 apiece during five of the 12 months.
If, on the other hand, you’d invested all of that money as a lump sum at the start of the year, you’d have a total of 240 shares and an average purchase price of $5 per share, and your investment would be down for the year.
Of course, if you were really lucky, you might have bought all of your shares in April, when the price dropped to $4 per share. But timing the market is an especially difficult task, even for the most seasoned professional investors.
By dollar-cost averaging, you were able to participate in the market and avoid buying at absolute highs (or at least avoid deploying all of your capital at absolute highs), increasing the likelihood that your investments would prove profitable over time.
Benefits of Dollar-Cost Averaging
1. Dollar-cost averaging can reduce volatility.
By spreading out the timing of your investments, you reduce the likelihood that you will be buying at an absolute market high or market low. This minimizes the effect of price swings and can reduce the overall volatility of your portfolio. Dollar-cost averaging is especially helpful during periods of high volatility when assets are swinging wildly in value on a daily or weekly basis.
2. Dollar-cost averaging helps you make investing a habit.
Dollar-cost averaging only works if you do it consistently. The good news is that if you do anything consistently enough, it’s more likely to become a habit. And once you’ve made investing a habit, you’re on your way to building real wealth.
3. Dollar-cost averaging discourages you from trying to time the market.
When you invest all of your money all at once, there’s often a pressure to time the market to make sure you’re getting the best price. But as noted above, timing the market is no easy feat, and it’s easy to become paralyzed into inaction by waiting for the perfect time to start. Dollar-cost averaging helps you get over this fear so that you can actually put your money to work.
How to Incorporate Dollar-Cost Averaging in Your Investment Strategy
If you’re participating in an employer-sponsored retirement account like a 401(k) that automatically invests the same amount of money each pay period, congratulations: You’re already dollar-cost averaging!
If you want to collar-cost average outside of a retirement account, all you need to do is:
Open an investment account.
Decide how often and how much you want to invest.
Set up the recurring investment.
Once you’ve got your recurring investment set up, the only thing left to do is to stay consistent and refrain from panicking during periods of volatility
Here at Allio, we offer a number of tools to help you automatically dollar-cost average as you invest. The ability to establish recurring investments and to round up the spare change from your purchases helps you make investing an automatic, everyday part of your life that you don’t even need to think about. Allio, works like a piggy bank in your pocket, but instead of the change laying dormant, we re-invest your money in an institutional quality, global macro portfolio, so your money can grow with compound interest in all market conditions.