Surely you have seen several methods to invest money in the markets from lump sum investing to attempting to time the market by “buying the dips.” So, is dollar cost averaging the investing strategy to beat? Let’s have a look.
Dollar Cost Averaging Defined
Dollar Cost Averaging is an investment strategy is a systematic practice of investing equal dollar amounts at regular intervals. An example would be to put $100 per month into a specific fund regardless of the price or of overall market conditions.
This strategy eliminates much of the risk of trying to time the market by making lump sum investments. Your risk is spread across many months or years to mitigate market volatility.
Dollar Cost Averaging works best as part of a long-term investment strategy. Think about your 401K plan. You are most likely investing the same amount per pay period into various funds over the period of several decades. Due to constant and consistent investing you are mitigating risk and are better able to weather market downturns.
Dollar Cost Averaging versus Market Timing
If you’ve been following the news recently, then you’ve seen an army of Reddit users trading in various companies such as AMC and GameStop. Some of them have made millions of dollars in a matter of months. You may have even been enticed into this world of trading and market timing.
Trading can produce huge returns, but it is a difficult and sophisticated strategy that most people will simply fail at. The rewards can be great if you are correct, but so too can the losses if you are wrong. Most people who try get it wrong.
Dollar Cost Averaging by contrast is passive and hands off. It doesn’t matter if the market is rising or falling. You will still be regularly investing. This is a good strategy for people who want their investments to be hands off and for people who don’t have a deep knowledge of the markets.
There have been endless experiments run where someone invests regularly for a long time period versus someone only buying when they believe that the market is in a bottom. Turns out that Dollar Cost Averaging beats market timing around 70% of the time even when the experiment is run so that money is only invested when the market is in a true bottom.
Timing the market can be rewarding, and some people are able to successfully pull it off. However, the average person who is a long-term investor would be better served by investing a fixed amount at regular intervals over a long time period.
If you want to try your hand at trading, then keep it limited to a small portion of your overall portfolio. Say, no more than 5%. In this manner you can try some trading and market timing strategies while keeping the bulk of your nest egg safe.
The main takeaway is that for the average investor Dollar Cost Averaging is still the strategy to beat.