September 7, 2019
Investing during times of market turbulence can be unnerving. Watching an investment you made one day lose 1%, 2%, or more the next day is disheartening. But there is a way for long-term investors to use market volatility to their advantage. It’s a technique known as dollar-cost averaging.
We’ll outline four steps to decrease market risk by dollar-cost averaging, but first we’ll dive into some basics…
Dollar-cost averaging is a system of breaking up an investment into different purchase lots at different times, typically at different prices. It is exactly as its name implies, owning an investment at an average price. Sometimes you’ll pay a little bit more for the investment. Sometimes you’ll pay a little bit less. It all averages out in the end. Here’s how it works.
Say, for example, that you wanted to buy shares of the SPDR S&P500 ETF, the proxy for the S&P 500. Let’s also say that you set your buy orders in advance to trigger purchases at the opening price on the first trading day of every month. In our example, these trades occur between September 3, 2018, and September 3, 2019. Our investment is made in twelve separate purchases of equal dollar amounts.
Now, let’s compare this strategy to simply buying the ETF all at once on September 3, 2018. Doing that would have cost $289.84. Your investment return (exclusive of dividends) after one year would have been 0.25%.
As you can see from the chart below, by breaking up the investment you would have paid less for the ETF nine times out of the twelve purchases.
(Chart courtesy of StockCharts.com)
The table below shows that dollar-cost averaging takes your blended price to $281.82. Dollar-cost averaging would have saved 2.77% on the total investment and created for you an annual return (again, exclusive of dividends) of 3.10%. (Source: Yahoo Finance)
Dollar-cost averaging would have benefited you in the above example, even though the price of the ETF was higher at the end year. And that’s the whole point. Dollar-cost averaging works, not because the market rose, but because the market was volatile. That volatility allowed you to make some of your investments at prices lower than had been available to you at the beginning of the period and at the end of the period. So, dollar cost averaging would have been more beneficial to you than if you had bought the ETF all at once at the beginning of the period.
Now, think about this with a long-term perspective. If your investment horizon is many years away (or possibly many decades as you plan for retirement), then the benefits of dollar-cost averaging just keep getting better. While the general trend of the US stock market has been up, there have been many periods of decline. Investors that follow a disciplined program of dollar-cost averaging can take advantage of those (mostly rare) declines. So, how can you make the most of dollar-cost averaging? Simple, make a plan.
Successful dollar-cost averaging, like most aspects of investing, begins with a solid plan. Here are the four steps you should follow before you begin.
The first order of business to make your dollar-cost averaging plan successful is to determine the proportion of your portfolio that is going to go into this specific investment. You’re probably going to want to consult your financial advisor about risk tolerance, consumption goals, and strategic asset allocation to help you arrive at this figure.
Once you know what your allocation to this investment class will be, you’ll need to determine how you want to gain exposure to it. You can use individual stocks or bonds, although bonds may be difficult to acquire over time in small amounts. But there are many types of investments for which dollar-cost averaging works. For many, dollar-cost averaging works best using index ETFs and/or mutual funds.
The time frame, in this case, is different than your investment horizon. That’s the length of time you intend to hold your investments in order to achieve some investment objective or to use the assets to finance a specific consumption goal. Here, we’re talking about the time frame in which you want to be fully invested in the security. This is a unique personal choice. You may decide that you want to be fully invested within a year. Maybe you want to continue contributing to the investment for the duration of your working life…or beyond. There is no right or wrong answer. Whatever it is just has to be comfortable for you.
Once you know how much you’re going to invest in the security, and you know the time frame over which you want to be fully invested, then you need to decide the frequency of your investments. Maybe it’s once a month, every 90 days, whatever. There is no right or wrong answer here. It’s whatever is most comfortable for you.
Successful dollar-cost averaging is akin to most successful investment strategies – stay the course. Don’t panic if the markets get volatile. Remember, volatility is what helps you buy at bargain prices and lowers your average cost. Holding on during these uncomfortable periods is what makes this strategy successful. But, don’t be complacent. Pay attention. If something doesn’t feel right, ask your advisor for guidance. Following these simple steps can help your dollar-cost averaging plan work for you in the long run!