Dollar-Cost Averaging: a completely risk-free investing strategy?
In an era where crises and volatility abound, investors are often on the lookout for investment strategies that can help to create some semblance of stability and predictability. One such widely accepted investment strategy is Dollar-Cost Averaging, which is targeted at investors with a lower risk tolerance and a long-termer investment horizon.
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Dollar-Cost Averaging is an investment technique where an investor purchases a fixed dollar amount of a particular investment asset – like shares of a company – on a regular schedule, regardless of its price.
So, for instance, if an investor wanted to buy shares in a company, each month, the investor would use a predetermined amount of funds to purchase shares at the current price. This means that the investor will purchase more shares when the price is low and less shares when the price is high.
Instead of regarding investment as a lump sum, it sees investment as a gradual process over time. This strategy protects the investor from market fluctuations and potential downside risk. By buying a fixed dollar amount on a regular basis, it focuses on accumulating assets rather than trying to time the market.
At the very core of this strategy, it requires a commitment to investing a fixed amount every month. Depending on the risk profile of the investor and the investment objectives, monthly contributions can. The thing about dollar-cost averaging is that one does not need to worry about when to invest and thinking of when to enter and exit from the market.
Dollar cost averaging makes sense as it takes away the fears of investing. How the market moves in the short-run becomes less important as there is consistency in your investments. With dollar cost averaging, market risk is reduced.
Let me illustrate this strategy with an example:
Assuming that an investor is looking to invest $2000 on the first of each month into Mutual Fund ABC. Over a period of 3 months, the share price of Mutual Fund ABC on the beginning of each month is as follows:
Month 1: $15
Month 2: $20
Month 3: $22
On the first of each month, the investor can buy a number of shares equal to $2000 divided by the share price. In this example, the number of shares purchased each month equals to:
Month 1 shares: $2000/ $15 = 133.33
Month 2 shares: $2000/ $20 = 100
Month 3 shares: $2000/ $22 = 90.91
Regardless of how many shares purchased with the monthly investment of $2000, the total number of shares the investor owns stands at 324.24. Considering that the current price of the shares is $22, this means an original cumulative investment of $6000 have grown into $7133.33
Looking at the example, the investment strategy of dollar-cost averaging seems like a fool-proof method of guaranteeing positive returns while investing. However, this is purely a theoretical example that may not accurately reflect the realities and nuances of investing.
Here are some of the downsides and things you need to take note of while engaging in such a strategy.
By any measure, this strategy is no guarantee for positive returns all the time. If this strategy is utilised in a scenario where share prices continue to fall, it may not be a wise move.
Also, this dollar-averaging strategy does not connote that you take your hands off the investment and leave it alone. It requires you to check your portfolio and understand your investments.
Dollar-cost averaging makes the assumption that across a period of time, there will be ups and downs in the market. It is very much dependent on the historical price movements in the market.
However, if the price of the shares constantly goes up, this might possibly eat into the returns you’ll be able to get compared to investing a lump sum from the beginning. Using the same example above, if a lump sum of $6000 was invested at the start, it will have grown to a sum of $8800, getting more than what you’ll gain from dollar-cost averaging. Thus, it would seem counter-intuitive to use dollar-cost averaging rather than employ strategic investing with a lump sum at the start.
If the share prices keeps going down, that can also prove to be problematic. This can be illustrated with the following example. Assuming that an investor is looking to invest in Mutual Fund DEF over a 3-month period with the following share prices of Mutual Fund DEF at the beginning of each month:
Month 1: $15
Month 2: $12
Month 3: $10
Going by these share prices, the number of shares purchased with a monthly investment of $2000 would equal to:
Month 1 shares: $2000/ $15 = 133.33
Month 2 shares: $2000/ $12 = 166.67
Month 3 shares: $2000/ $10 = 200
In this case, the total cumulative number of shares will be 500. Considering that the current price of shares is $10, the original investment of $6000 over the 3 months will see a return of $5000, incurring a loss of $1000.
Therefore, one mustn’t assume that dollar-cost averaging will work for them in the long run. Given that dollar-cost averaging is very heavy on the premise that there will be ups and downs for it to work, the uncertainty of the direction of the market makes it a strategy that is risky to employ when one does not understand market well.
Overall, Dollar-cost averaging may be seen as a largely stable and risk-free way of investing. Advocates prize it highly as a way to tide through the turbulent fluctuations of the market. Nonetheless, if utilised on its own, this strategy can be bluntly inefficient and clunky and sometimes illogical in protecting yourself against risk. Like all other investing strategies, it is essential to do your homework and understand what you’re going into before deciding to invest.
Deciding whether to use a particular investment strategy varies from person to person, and it is highly encouraged that you find out which investment strategy works the best for you before you decide to invest. Dollar-cost averaging may protect you from some setbacks but it may not be the best investing strategy in the long run.