Ask any psychologist and they’ll tell you: human beings are irrational.
Love, fear, greed, and a plethora of other emotions prompt even the most levelheaded of us to make decisions that are often against our best interests.
Throw in a little fear about erratic stock market performance (like last month’s peaks and valleys), and many of us otherwise rational humans often break the number one tenet of investing advice. Namely, we panic and sell at the bottom of the market.
The good news is that is that there’s an investing strategy that can help us sidestep our irrational tendencies and set up an automatic investing program that allows us to buy more of an investment when prices drop and less of it when prices rise. It’s a classic strategy called dollar-cost averaging.
What is Dollar Cost Averaging?
Dollar Cost Averaging (DCA) is the act of buying a fixed amount of an investment at regular intervals. When the cost per share is low, the investor is able to buy a greater number of shares. Likewise, fewer shares are purchased when the price per share is high.
“Dollar cost averaging is an effective psychological tool,” says Stephanie Genkin, independent fee-only financial planner and adjunct instructor at NYU’s School of Professional Studies. “It enables investors to take the emotion out of investing, especially when markets are volatile.”
Take last month, for example. “Stocks dropped 300 points by the end of the week of December 12 – a 3.8 percent loss, making it the worst weekly performance in more than three years,” says Genkin. When media pundits warned the drop could be the beginning of a larger market decline, many investors panicked.
A dollar cost averaging strategy, meanwhile, can help investors maintain a level head, especially when markets face chaos. “The thought of buying stocks in a dropping market is very scary for most people. But, less than a week [after the 3.8 percent decline], the Dow jumped more than 400 points, making it the single best day on Wall Street in more than three years. It just goes to show, if you snooze, you lose,” says Genkin.
The number one advantage of DCA is that it helps investors stay invested, even when their brains want to run away from the market, screaming in fear. “You can’t time the market,” says Genkin. “Dollar cost averaging takes away all the temptation to try (and fail).”
How Does It Work?
If you invest in a 401(k), 403(b), or other large-scale retirement plan that requires investment at regular intervals, you’re already dollar cost averaging. Congratulations! If you’re not or want to branch out to other investment options like an individual IRA, mutual fund, or corporate stock, a DCA strategy can help keep you from jumping with fear when markets turn sour. Any time an investment is liquidated, it no longer has the opportunity to benefit from market gains, which often come when we least expect them.
With that in mind, let’s take a look at a few charts that help show how exactly DCA impacts an investment.
How Irrationality (Fear) Hurts an Investment Portfolio
Even though we think we will, the hard truth is that we humans don’t always make rational decisions, especially when we’re afraid. I’ve created this anecdotal graphic to show how many investors can and do react to market ups and downs.
How a Systematic Investment Strategy Smooths Out Rough Patches
By using a DCA strategy, the investor is less likely to panic and sell his shares when the market declines. Even though the stock price fluctuates during the year, the investor pays an average of $26.92 per share during the year for a total of 89.28 shares. (Note: you can buy fractional shares in a mutual fund but typically not in a stock.) The investor remains invested in the market and can take advantage of the upswing that happens toward the end of the year.
|Investment Month||Amount Invested||Price Per Share||Number of Shares Purchased|
|Total Invested||Average Cost Per Share||Total Shares Purchased|
“By investing set amounts in funds at predetermined intervals, you not only set it and forget it, but the screaming headlines don’t matter to you anymore,” says Genkin. “Our instincts are all wrong for making money in the stock market. DCA is the way around it. It takes all the guesswork out of when to invest.”
The ‘DCA Drawback’
For investors sitting on a lump-sum of cash that’s ready to be invested, DCA may have have its drawbacks. Finance professors Richard E.Williams and Peter W. Bacon found that a lump-sum investment will perform better most of the time (two thirds of the time, to be exact) during the first year than will an investment using the DCA method.
Since most of us are investing as we make our money (from our paychecks, that is), we’re most likely better of using a DCA strategy. The lesson to be learned from Williams and Bacon, though, is that sitting on a sum of money so you can evenly distribute it over the course of a year may not be the best strategy.
For the rest of us without a big pile of cash burning a hole in our investment pockets, though, have fun with dollar cost averaging.
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