This is part four of a series on investing in a volatile market. Click here for part one on creating a financial roadmap; click here for part two on evaluating your risk tolerance; and click here for part four on diversifying using a risk pyramid.
It can be tempting to make large lump-sum contributions to your investment portfolio once or twice a year, but a successful investing strategy often involves the use of dollar cost averaging. This strategy is particularly useful in a volatile market because you reduce the risk of accidentally investing all your money when prices are high. The key is to buy low, so by spreading out your investments throughout the year, you’re not investing everything right before the market falls.
ValueWalk's Raul Panganiban interviews Kirk Du Plessis, Founder and CEO of Option Alpha, and discuss Option Alpha and his general approach to investing. Q1 2021 hedge fund letters, conferences and more The following is a computer generated transcript and may contain some errors. Interview with Option Alpha's Kirk Du Plessis
The benefits of dollar cost averaging
Dollar cost averaging basically just means setting a specific amount of money to invest at regular intervals. The process involves investing the same amount of money multiple times throughout the year, so no matter what the market is doing, you're still pouring money in. Dollar cost averaging can be especially helpful during lengthy bear markets because the market is down or flat for a longer period of time.
One benefit of investing the same amount of money at each interval is that you're buying more shares of whatever asset you're buying when the price is low and fewer shares when the price is high. The dollar amount remains the same, but the share volume goes up and down with the market.
Dollar cost averaging also enables new or less experienced investors to get started with a relatively small amount of money. There's no need to wait until a large, lump sum is available because you're putting set amounts of money into the fund or asset continually throughout the year. The strategy also means you're continuing to invest toward your goal rather than stopping and starting repeatedly. By staying invested, you are more likely to achieve your goals.
Strike just before volatility hits
Various studies indicate that dollar cost averaging is particularly helpful during times when the market is falling, which is why the Securities and Exchange Commission suggests considering it during times of market volatility.
Nerd Wallet put together some scenarios to explain how the strategy works and demonstrates why it is an especially useful strategy during volatile markets. In this scenario, $10,000 is split equally into four purchases with prices ranging from $25 to $50 over a year. When the share price of the asset being purchased is lower, more shares are bought, and when it's higher, fewer shares are bought. As a result, the number of shares purchased will end up being more because you're adding to your investment after the price drops instead of sinking your entire $10,000 in at the very beginning. In this scenario, you end up with almost 300 shares of the asset you're investing in.
On the other hand, if you put all $10,000 in at once when the share price was $50, you would only end up with 200 shares. You end up with roughly the same result when the market is trading sideways, so the best-case scenario is to do this while the market is falling. Thus, when the bear market finally ends, your 300 shares should increase in value, and since you own more of them, you're in a better situation than if you invested the entire lump sum in at the beginning before the market started to fall.
When dollar cost averaging doesn't work
Of course, no investing strategy is perfect. As with any other strategy, there are some downsides. For one thing, the more transactions you make, the more you pay in fees, so you will need to keep that in mind when deciding on the length of the intervals you want to space out your investments by. Additionally, this technique is about adding to your portfolio steadily rather than trading in and out all the time.
Dollar cost averaging isn't a good idea when the markets are climbing steadily because you buy fewer and fewer shares at higher and higher prices and ultimately just end up losing money. Thus, it often represents a winning strategy during a volatile market because you're buying low with the plan of selling high later.
To learn more about dollar cost averaging, speak to your financial advisor or trading professional to get set up with a plan.
This article first appeared on ValueWalk Premium