Dollar-cost averaging means scaling into (and out of) investments over time, rather than all at once. Learn the basics to help you decide if and when dollar-cost averaging could be appropriate for your portfolio.
Dollar-cost averaging is a straightforward strategy that you can use even in the most complex economic circumstances
When dollar-cost averaging, it’s important to think of small chunks rather than big bets
Consider dividend reinvestment as part of a dollar-cost averaging strategy
Markets fluctuate—throughout every trading day as well as in big, multi-year cycles—from bull to bear and back again.
The beginning of 2020 marked the first bear market since the 2008 financial crisis. The new bear was triggered by fears surrounding the COVID-19 pandemic; we witnessed some of the largest selloffs—and largest rallies—since the crash of 1987.
Although we don’t know how or when the 2020 bear market might end, we do know that, historically, all bear cycles since the Great Depression ended at some point, and were followed by fresh advances.
As an investor, you’re probably asking yourself, “What should I do in the meantime?” Good question. Should you sell everything in a frenzied panic, or should you continue to build your portfolio carefully and strategically—that is, dollar-cost average—as stocks sink toward bargain-basement prices?
Buying a stock on a “dip” can be uncomfortable. Buying into a steep correction might feel even worse. Strategically building up a portfolio during a bear market or recession might feel downright unbearable. But should it be?
Of course, you shouldn’t be staking all your money on a single stock. But do you really believe that, over time, a well-diversified position made up of many companies that represent a good portion of the U.S. economy might terminally sink? All things are possible, of course. But some things are much less probable.
Chances are that your long-term investment in the U.S. stock market could yield favorable returns once the bull reemerges. The question is, what are the ways one might capitalize on this cyclical turn? Put more bluntly (perhaps ironically), what’s an effective way to keep “buying low” when the markets are, well ... low and moving lower?
Dollar-cost averaging (DCA) is about buying shares in small chunks and on a regular basis, regardless of price.
Think about it this way:
Not only might this investment strategy be an effective way to grow your portfolio over time; it can also be a prudent way to navigate the complex and often nerve-racking conditions of a stormy economy. DCA investing as a matter of principle and habit can help you eliminate a lot of emotional angst—thinking about whether to invest, how much to invest, whether to stay out, and when to get back in.
If anything, dollar-cost averaging may be better than attempting to time the market. Think about it: nobody can predict the turns of the market. Humans just aren’t good at knowing the future. As a result of this deficiency, many investors who attempt to time the markets end up:
A lesson for long-term investors: it’s not about timing the market; it’s about time in the market.
With that said, DCA investing keeps you engaged in the markets. Sure, you’re exposed to market risk. But you’re also exposed to growth opportunities. Although past performance is no guarantee of future returns, over long periods of time, history has favored the bulls over the bears.
The good news is that dollar-cost averaging is not rocket science. The better news is that its simplicity can help you cut through the complexities of fundamental knots that may not be fully understood.
You might even be employing dollar-cost averaging without realizing it. Do you contribute to a company 401(k) plan—with or without a company match? Those regular contributions are typically a fixed dollar amount, invested at regular intervals into your predetermined allocations.
Here’s another: Do you own any stocks or funds that automatically reinvest dividends? Some companies offer dividend reinvestment programs (DRIPs) that allow investors to receive dividends as additional shares instead of cash. If you like the idea of reinvesting dividends, but your stock isn’t part of a DRIP, you could reinvest on your own by tracking your dividend payments and, whenever you’ve earned a certain dollar amount in dividends, buying as many shares as you can at the prevailing price. That’s also dollar-cost averaging.
How often have you heard these trading maxims?
These popular nuggets have some truth to them—particularly in the case of short-term market plays. For example, if you think a stock has become oversold, and you try to scoop it up in mid-fall, it’s unlikely you’ll nail it at the bottom. That’s the falling knife.
Are you nearing retirement and moving from “accumulation” to “decumulation?" Has a recent spate of volatility pushed you to review and potentially rebalance your portfolio? Consider a DCA strategy to help you scale out of your positions over a period of time rather than all at once.
The second maxim is about stubbornness. Hanging onto a bad trade—or worse, adding to it—long after it’s failed to match your objectives is a recipe for underperformance. But dollar-cost averaging is neither of those things. Remember, with this strategy you’re investing for the long term, not trading for short-term gain.
During a bear market or recession, assets fall across a wide range of sectors. Think of it as a discount buying season. If you catch these falling assets in small chunks as they continue to fall in price, that can be smart investing.
But if you go “all in,” depleting most of your investable funds to the point of having no buying power left, then the assets you bought are now “falling knives.” You may be stuck with them for a long time as their values continue to drop. Not only might you get stuck holding your stocks for months, the worst part is that you’ll have no money left to buy even more high-value stocks as they hit discount prices.
With weather and the market, sometimes it rains and sometimes it shines. DCA stock investing is a straightforward strategy that can help you navigate both sunny and rainy days in the market.
More importantly, making a habit out of it can help you build your portfolio without the analytical hassle of trying to pick “winners” every time or the emotional hurdle of trying to time the markets. You might get scratched by the occasional bear, but scaling into positions during such times might help your portfolio come out bigger and stronger when the bull wakes from its slumber.
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Karl Montevirgen is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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