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Is Dollar-Cost Averaging Worth It?
Dollar-cost averaging is an investment strategy that can really save your neck in the right circumstances. But it’s a strategy that I avoid when I can. Today I’ll go over what dollar-cost averaging is, why it works, and why it (usually) isn’t right for me.
What is Dollar-Cost Averaging?
Even though I think the stock market is a great place to invest, it has a pretty big weakness: Volatility. It goes up and it goes down. Sometimes the swings can be jarring. And as bad as the market as a whole is, individual stocks are worse.
One area where the market’s volatility can work against you is when prices fall right after you invest a large amount. Let’s consider an example. Imagine you have $5,000 to invest and you buy into an index fund at $100 per share. But next month, the price drops to $70 a share:
In this example, your investment has quickly lost $1,500. It’s not quite as bad as it looks, the loss is only a “paper loss.” In other words, you only actually lose money if you sell. The deeper problem is the opportunity cost. Take a look at those 50 shares that you probably glossed over in the last table. Then compare that to what would have happened if you had invested in month two:
If you had just waited a month, you could have had more than 70 shares instead of 50! Let’s pretend that at the time you eventually sell, the shares have gone up from $100 a share to $1,000 a share. Those extra 21.43 shares would have been worth $21,430. Ouch!
How can you avoid tragedies like this? Why, with Dollar-cost averaging of course.
Why Does Dollar-Cost Averaging Work?
Dollar-cost averaging spreads out your investment, forcing you to buy fewer shares when the price goes up, but allowing you to buy more shares when the price goes down. It flips the normal script on its head. Normally, a drop in price after you invest a lump sum is a bad thing. But if you are dollar-cost averaging, you only invested part of your money. Your next installment will take advantage of the lower price.
Stated simply, dollar-cost averaging gets better the more the price drops in the short term. So in this way, it’s the opposite of lump-sum investing.
