Many people don't know what dollar cost averaging is, how it works or why they might want to do it. In this article we'll discuss the basics of dollar cost averaging and explain how it helps investors avoid big losses during market downturns as well as providing stable returns long term.

Time In The Market Beats. Timing the market

Market timing is a strategy where investors attempt to predict future stock prices. This is done by looking at historical data and trying to determine what the next trend might be. If you think the economy is about to turn around, for example, you could buy stocks that are expected to do well once the economy picks up steam. On the flip side, if you believe the economy is headed south, you could sell off shares of companies whose sales are likely to decline.

The problem with market timing is that it doesn't always make sense. Markets don't always behave predictably, and determining whether an asset is under valued or over priced is extremely difficult. As a result, you may decide to "wait for the dip" on an asset but instead the asset rises rapidly and you miss out on gains.

Or on the other hand, you may sell a stock you think will go up in the long term because you think it may go down in the short term and you might be able to make a quick profit. Well that may happen. But the stock may also continue to run up and if you have to buy back in at higher prices, then you have just missed out on some more profit.

The whole idea behind dollar cost averaging is that you don't care about the price at the time you buy. You just consistently buy the same asset over a long period of time in regular intervals. Historically this has shown to be more consistent for investors then trying to trade on short term moves. 

How Does Dollar Cost Averaging Work?

When it comes to investing, one of the most common ways people try to save money is dollar cost averaging. In fact, according to Investopedia, about half of investors use this method. But what exactly does dollar cost averaging mean? And how does it work?

To understand how dollar cost averaging works, let’s start with an example. Imagine that you want to purchase 10 shares of company X. Instead of purchasing all of these shares in one go, you may instead decide to purchase 1 share each month for 10 months.

Or (the way I do it), each month after getting my pay from my fulltime job. I add whatever money I have to invest that month into all of my favourite stocks. I don't care about the share price that particular day because many of my stocks are long term plays. I don't expect to sell for 10+ years, unless my conviction changes.

Rewards of Dollar-Cost Averaging

The key to dollar-cost averaging is to stick with it long enough to see a difference. On a day-to-day basis anything can happen. The advantages and disadvantages below are in line with what to expect if you stick to this strategy long term.

Advantages of dollar cost averaging

The concept behind dollar cost averaging is simple: you buy shares of a stock over time rather than paying full price for it all at once. This method helps to keep emotions out of the equation because there are no big decisions to make about whether or not to invest.

This strategy allows people to purchase items over time without having a lot of money available. For example, let’s say you want to start investing in stocks. You can start with very little money, even £10 per month to get started.

You can set up recurring payments through your bank account or credit card so that you never need to worry about running out of funds. Dollar cost averaging can become very automated so you don't even need to think about it. Especially when picking something like an index fund with a diversified basket of stocks.

Disadvantages of dollar cost averaging

Dollar cost averaging isn't right for everyone. If you're looking to make a large investment, you'll probably want to consider buying everything at once. Also, if you're new to investing, you should wait until you've built up a bit of experience before diving headfirst into dollar cost averaging.

If you're a novice investor who wants to learn about investing, you might also find it difficult to stay disciplined. When you're learning, it's easy to get distracted by other things.

It's important to note that dollar cost averaging doesn't guarantee success. There are plenty of examples where people have still failed at dollar cost averaging due to making the wrong stock picks.

Does Dollar Cost Averaging Really Work?

There are two main reasons why dollar cost averaging works. First, it gives you more control over your investments. By choosing to invest small amounts every month, you can avoid being swept away by emotion and impulse purchases.

Second, dollar cost averaging makes sure that you always have some money invested. Even if you only put £1 per month, you will eventually end up with a fair amount in your portfolio

A Long-Term Strategy

The stock market tends to go up and down over short periods of time. But it doesn’t always move in one direction. There are times when the market goes up and there are times when it goes down. This is called volatility. In fact, the average investor loses money during a bear market.

Over the long term, the overall market tends to trend upwards. This means if you could average out your purchases over time you should be able to match the average returns of the stock. In fact, this is exactly what happens.

Gaining this average price of the share over time helps smooth out any volatility along the way. If the stock does tank in share price then this means the next time you're due to buy, you will be lowering your average cost in the long term which is a good thing. On the other hand, if the stock goes up now then you are in profit which to no surprise... is also a good thing.

Summary

Dollar cost averaging is a great long-term strategy because it ensures you always have some money in the market. It also helps you gain an average return on your shares over time. However, it may not work for all investors that want a more fast paced investing approach.

I am not a financial advisor and anything I say in my blog is not to be taken as financial advise. For any financial advise please contact a financial professional. My blog is based on my own opinions, research and understanding of the financial markets.

I hope you have found this blog post helpful. If you did enjoy the blog then consider leaving feedback below or sharing the post on social media. I regularly post content on the stock market, personal finance, and side hustles/entrepreneurship so if you would like to read more then consider subscribing to my blog through my website (www.portfolio-hub.co.uk) for free or follow me on Medium.com.

Thanks for reading

FAQ

Who Should Use Dollar-Cost Averaging?

The investment strategy of dollar-cost averaging can be used by any investor who wants to take advantage of its benefits, which include a potentially lower average cost, automatic investing over regular intervals of time, and a method that relieves them of the stress of having to make purchase decisions under pressure when the market is volatile.

Source: investopedia.com

Does Dollar Cost Averaging Really Work?

Outside of hypothetical examples, dollar cost averaging doesn't always play out neatly. In fact, research from the Financial Planning Association and Vanguard has found that over the very long term, dollar cost averaging can underperform lump sum investing. Therefore, if you do have a large sum of money, you're generally better off investing it as soon as possible.

Source: forbes.com

Why dollar-cost averaging works

Dollar-cost averaging works because it removes some of the emotional stress that comes with investing. By committing to a set schedule, you don't have to worry about whether a stock is about to move higher or lower.

Source: fool.com