Dollar cost averaging is a fancy name applied to a simple investment concept: buying according to your established investment strategy as funds become available.
I’ve recently written articles discussing the risks involved in trying to time the market (link to market timing piece & day trading piece). The obvious appeal of buy high, sell low isn’t always as attainable as investors would like to believe. A more reasonable alternative for common investors is buy high, buy low (and maximize holding periods).
No consideration is paid to the level of market prices or prevailing trends. In effect, the strategy entails nothing more than investing money as you get it. The “averaging” aspect comes from instances of investors putting the same amount of money into the market at pre-determined time intervals, such as bi-weekly or bi-monthly to coincide with your pay periods.
Dollar cost averaging is the ultimate hedge to risks associated with market timing. The strategy is also effective in investing lump sums. Though I have previously written that time in the markets is more important than timing the markets, and timing the markets is laden with risks associated with the unpredictability of short-term price fluctuations, many investors struggle with putting a lump sum into the markets in one fell swoop. Investing is as much psychological as it is formulaic, and insulating yourself from regret can protect you from rash decision making. The best way to do this is by using a dollar cost averaging approach to disburse the funds in equal increments over a set timeframe.
Dollar cost averaging is an effective strategy when it comes to a diversified asset base defined by your investment objectives. Some stock market participants erroneously use the term “dollar cost averaging” to refer to buying more shares of a stock as its price drops in order to lower their cost per share, as they believe that the stock will inevitably bounce back. In reality, some stocks never bounce back. The investor who believes that he was astutely lowering his cost per share has instead caught a falling knife. This is a risk that is so frequently missed in the “buy low” fallacy; while the stock market as a whole has proven to be resilient, individual stocks often collapse. Many fortunes have been lost by investors mistaking a death spiral for a bargain purchase.
When it comes to succeeding in long-term investing, winning pretty much boils down to not losing. If there’s one thing history has taught us, it’s that the stock market’s long-run projection is inevitably upward. The short-term shocks on index pricing charts look like minor blips when viewed in a sufficiently long timeline. Dollar cost averaging is therefore an exercise in patience – trying to rush gains through market timing so frequently leads only to magnifying losses.
One of the most important lessons an investor can learn is humility – admitting when you don’t have all the requisite information, damaging as it may be to the ego, will protect you from bad decision making. When being average is all you need to do to win, why should you take the chance of being wrong?
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