Exchange-traded funds (ETFs) are ideal for beginners, but that's not all there is to it. Like all other kinds of investments, it's all about making smart choices. Such choices come only from those who have a strategy. As an investor, you probably have heard about the dollar-cost averaging investing process. But what is it exactly? And how does it work?
In a nutshell, Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total investment amount. It gets divided across periodic purchases of a target asset to reduce the impact of volatility on the purchase.
If you plan on using such a strategy, you may want to know a bit more about how it works and if it does work.
Without further ado, let's get into it!
What is dollar cost averaging investing strategy?
As I said earlier, dollar-cost averaging is also known as the constant dollar plan.
It works by dividing up the total amount of investment across a target asset’s periodic purchases. This way, it tries to reduce the impact of volatility on the total purchase.
Instead of making one lump-sum purchase, the investment gets divided into smaller sums. It does so at regular predetermined intervals until the full amount becomes exhausted.
Through this strategy, you'll cut the volatility risk by attempting to lower the total average investing cost.
Does dollar cost averaging really work?
According to Vanguard's research, investors who used such an approach experience significant growth in their investment.
It is slightly less that they should have invested a lump sum. Further, it would be best to keep in mind that lump sum beats the strategy most of the time.
As always, it would boil down on your preference, whichever suits your goals, and how you tolerate risks.
Dollar cost averaging example
To give you an example of a dollar-cost averaging (DCA) strategy, take a look at the following.
For instance, there is an investment of about $200,000 in assets. It can happen over eight weeks through investing $25,000 weekly.
The total amount spent would be $200,000, while the total number of shares purchased with a lump-sum investment would differ.
Under the DCA approach, you can have more or fewer shares depending on the next eight weeks’ price.
The strategy can increase the number of shares purchased when the market declines. Further, it can lead to fewer shares if the price is rising.
Benefits of dollar-cost averaging
Below is a rundown of the benefits you can enjoy should you ever try the DCA strategy.
Risk reduction
With such a strategy, you lessen the risk of investing your assets. Moreover, the capital gets preserved to avoid a market crash.
Lower cost
With the DCA strategy, you can buy more securities than if you did so when prices were high.
Ride out market downturns
A portfolio using DCA can keep a healthy balance. Further, it can leave the upside potential to increase portfolio value in the long term.
Disciplined saving
The strategy of adding money allows a disciplined saving. With such, you add more balance even if its value depreciates. Of course, it would take a toll if the decrease becomes quite massive.
Prevents bad timing
Investing in a lump sum at the wrong time can be quite risky. Thus, it can affect a portfolio significantly. Such a strategy will provide a smoothening of the cost, which can benefit the investor.
Manage emotional investing
The use of DCA eliminates or reduces emotional investing. Such an emotional effect usually happens after investing a lump sum.
Cons of dollar cost averaging
Below is a rundown of the downsides you can experience should you ever try the DCA strategy. Understanding such risks would help you weigh down and prepare for the worst.
Higher transaction costs
Since you purchase small amounts over a certain period, the transaction costs can turn out high.
Asset allocation priority
Some critics say that a strategy should focus on the desired asset allocation to manage risk. A DCA will worsen uncertainty since the target asset takes longer to reach.
Low expected returns
Since the said strategy offers low risk, it would also mean you'll have low returns. Thus, while you can enjoy the low-risk, you also won't have the potential for a high return rate.
Complicated
Since you will divide your investments and do them over a certain period, it can be quite complicated. Further, it is quite a tricky task to monitor and track each contribution than a lump-sum investment.
Should you use dollar cost averaging for ETFs?
The use of such a strategy depends on your goal and preference. The pros and cons stated above should give you an idea of the strategy's benefits and risks.
If you plan on investing through an ETF, the strategy can be a little overrated since it provides easy investment options. With ETFs, you will have the flexibility and won't have to worry too much about risks.
If you're someone who wouldn't mind risk, then you may want to consider other strategies that offer higher returns.
However, the DCA can be perfect for people who want absolute security and feel contented with low returns.
In the end, it will be you who will decide which strategy suits your goals.
Summary
The Dollar-cost averaging is a great investment strategy that lessens investors’ risks. It happens by dividing assets and investing them over a specific time.
Investment strategies are always crucial in making the right decisions and actions. A smart investor would weigh down all strategies and see which one fits his goal and preference.
If you're a person who wants to invest without facing too many risks, the DCA may just be ideal for you.
Published: 02/17/2021