Nobody likes to see market prices fall. But it’s a normal part of the market cycle. Three years in four the markets show annual gains, but there is still that one negative year every so often. For most investors, and especially those participating in their employer’s retirement plan, lower market prices can be very helpful to your long term goals. And, if the market is volatile, that is large changes in price from one day to the next, then this situation can be especially helpful.
Dollar Cost Averaging
I’m talking about the benefits of systematically adding to your investment accounts over time. It’s a technique called dollar cost averaging (DCA). For some people, the rapid changes in investment prices, and the large red numbers they see some days, tempt them to “wait for things to get better.” But this idea is dangerous. It’s called timing the market and history shows that it’s extremely hard to do well. No investors have actually mastered it.
But if you invest consistently over time, market volatility can be your friend thanks to dollar cost averaging.
What Is Dollar-Cost Averaging?
Dollar cost averaging is systematic additions to an investment account over time. You buy the same dollar amount of an investment periodically over time. A great example is your 401(k) at work. You invest $500 each month from your paycheck. At the end of 12 months, you have invested $6,000 but you bought investments at 12 different prices. In volatile markets, spreading purchase out over time can really help. Here’s how:
- Your investments set up automatically, so you don’t have to think about it. And your are less likely to stop if the market gets a little wild.
- Your investments are made at different prices over time. When the price is low your money buys more shares. When the price is higher, you buy fewer shares. Over time the average purchase price of your shares will be less than the average price you paid for those shares.
The green line shows the prices at which you bought shares. The dotted line shows the average cost of those shares.
The benefits of dollar cost averaging are enhanced during market declines. The lower investment prices allow your monthly purchases to gobble up extra shares and prepare you for the inevitable recovery.
For example, suppose an investor has $600 in January and wants to invest it in a mutual fund. But the market is declining. So, she considers investing $100 a month over the next six months.
The chart below shows the hypothetical example: At the end of the six months, she owned more shares at a lower price per share.
As I mentioned earlier, it’s tempting to try to pick the bottom of the market cycle. Investors call this market timing. And it’s a big trap for many investors. Academic research in finance has proved that trying to time the market accurately is nearly impossible.
Warren Buffet, Chairman and CEO of Berkshire Hathaway is widely regarded as one of the best investors in recent history. Here is what he said about market timing in April 2022 a the Berkshire annual shareholders meeting:
“We haven’t the faintest idea what the stock market is gonna do when it opens on Monday—we never have.”
One of my favorite sayings is that Time in the Market Beats Timing the Market. This talks about the power of owning shares and receiving dividends over time. Since the movement of market prices is extremely random, we never know when the market will rise. If you own shares, you will benefit from every market increase.
As you consider where dollar cost averaging fits in your financial game plan, you have a lot to consider. Maybe you would benefit from the advice of an experienced, well-trained CERTIFIED FINANCIAL PLANNER™ professional. As a financial planner who is ALWAYS the client’s advocate – a fiduciary advisor – I love talking with new people about their goals and priorities. If you would like to talk with me about your situation, I would love that. Just follow this LINK to find a time that works for you.
Yes, I am a CFP® professional. I’m always a fiduciary and I work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office at email@example.com. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.
This dollar-cost-averaging information is for illustrative purposes only and is not intended to represent any particular investment product. This dollar-cost-averaging strategy does not assure a profit or protect against loss in declining markets. To fully take advantage of it, be prepared to continue investing at regular intervals, even during economic downturns.