- Dollar Cost Averaging is the technique of systemically funding and investing savings based on a recurring timeframe.
- This strategy is used to avoid complications with attempting to time market bottoms and tops.
- We also believe this is a beneficial strategy from a behavioral perspective, as funding is often incorporated into a monthly budget.
The recent market volatility has raised many questions with clients regarding whether or not they should be funding investment accounts at this time. This recent mindset is a brief glimpse into behavioral finance and how investors view risk at different points in time. There is much more hesitation during the volatile 2022 rather than the bubble-like rally we saw in 2020 and 2021. However, prices have fallen substantially this year technically, stocks and bonds could be viewed as “on-sale” or “cheap” compared to the price levels of the past couple of years.
How Does Dollar Cost Averaging Work?
The general philosophy for long-term investors is to Dollar Cost Average into your positions over time. This strategy is defined as consistent funding and investing regardless of current prices and recent volatility. The keyword is consistent. Obviously, the most efficient strategy would be to sit in cash until the market bottoms and buy all in at that exact time. However, even for the most experienced wealth managers, that is a challenging task. Trying to time the market bottoms and tops can be very detrimental to your long-term savings potential, not to mention the stress that comes with it.
What are the Benefits of Dollar Cost Averaging?
Dollar Cost Averaging is beneficial during market downturns as you will continue to buy more and more shares as prices fall. This will lead to your average cost per share being lower than when you initially started to believe. However, this strategy will raise your average cost during a bull market as you continue to buy shares at higher prices. Also, when prices rise and you invest the same amount, you will be buying fewer shares. More shares are bought with the recurring investment amount when prices fall. This strategy will tend to lower your overall cost basis if followed over a longer term.
Best Time to Start Using Dollar Cost Averaging?
Trying to time the market may lead to missed opportunities or mistakes that lead to a higher cost basis in any scenario. With a long-term view, the market will likely recover from volatility and lead towards higher levels, so investing the savings may be more beneficial rather than trying to time entry points perfectly. Dollar Cost Average supports the old saying of, “time in the market is more important than timing the market.” Trying to time the market may cause you to miss potential gains, so focusing on your savings being invested sooner may increase your growth potential over the longer term.
How to Budget a Dollar Cost Average Strategy?
This strategy is also especially useful from a budgeting and psychology perspective. For example, let’s consider the $6,000 IRA contribution limit. Investors who are following the Dollar Cost Average strategy would choose to invest $500 per month. Someone trying to time the market may hold onto all $6,000 until they hopefully identify the best opportunity for the year and then invest it all at once. This could backfire if prices rise all year and they invest the lump sum near the deadline, or it may benefit them if the market falls all year and the best price is near the contribution deadline.
However, consumer behavior has shown us that some individuals would struggle to hold onto that $6,000 for a longer period and may end up spending it on something other than retirement savings. By using the Dollar Cost Average at $500 per month, builds the savings into your monthly budget and forces you to commit to that goal. As a result, you are more likely to follow your savings plan when it is set up as a systemic or recurring investment.
Speak With a Trusted Advisor
If you have any questions about increasing your income, retirement planning, taxes, our 401(k)-recommendation service, or anything else, please call our office at (586) 226-2100.
Please feel free to forward this commentary to a friend, family member, or co-worker. Also, if you have had any changes to your income, job, family, health insurance, risk tolerance, or overall financial situation, please call us so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them.
Zachary A. Bachner, CFP®
with contributions by Robert L. Wink, Kenneth R. Wink, James D. Wink, and James C. Baldwin
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