You Can't Time The Market So Try Dollar Cost Averaging Instead

Peter's picture

"Buy low, sell high" is often one of the first things you'll hear when you're learning about investing. The problem with this is that it's tough to know what "low" and "high" actually are even when they are staring you in the face. When markets seem like they are down, like they are today, it can seem risky to make a large investment in case the markets keep going down. One way you can help limit your risk while entering into a falling market is through Dollar Cost Averaging.

Dollar Cost Averaging

Dollar Cost Averaging basically means investing a fixed amount of money at regular intervals, regardless of the market price of the investment. So, if you've ever set up an automatic investment plan that invests an amount of money each month, then you've made use of Dollar Cost Averaging. It's a pretty fancy term describing an otherwise simple concept.

If we take a look at my (highly contrived) example in the illustration below we can see the effects of Dollar Cost Averaging.

Dollar Cost Averaging: This is one method for reducing the risks of getting into a falling market.Dollar Cost Averaging: This is one method for reducing the risks of getting into a falling market.

Here's what is happening in the illustrated example:

Our one-time purchase of 300 units for $900 left us with $1500 at the end of the day.

Our Dollar Cost Averaging approach went like this:

  • Our first $100 purchase got us 33.33 units.
  • Our second $100 purchase got us 100 units.
  • Our third $100 purchase got us 33.33 units.
  • Our fourth $100 purchase got us 25 units.
  • Our fifth $100 purchase got us 25 units.
  • Our sixth $100 purchase got us 33.33 units.
  • Our seventh $100 purchase got us 33.33 units.
  • Our eighth $100 purchase got us 33.33 units.
  • Our ninth $100 purchase got us 20 units.

So, in the end, we got 336.67 units for a total cost of $900 with a final value of $1683.33 by using Dollar Cost Averaging, which is about 12% better than the lump-sum investment.

If you take a closer look at our Dollar Cost Averaging approach, you'll see that the second purchase, of 100 units at $1 each, makes this investment method work out better overall. Even though we bought twice at $4 and once at $5, that single purchase at $1 allowed us to finish ahead of the $900 lump-sum investment. It's this natural tendency to purchase more of an investment when the price is low and less of it when the price is high that makes Dollar Cost Averaging work.

Why Use Dollar Cost Averaging?

Dollar Cost Averaging is a method for reducing the risk of entering into a potentially volatile investment. For example, over the past 10 days the Dow Jones Industrial Average market index has fallen from 12,700 to 11,700. If, ten days ago, you had invested $10,000 into an index fund that tracked that index you would be currently holding an investment worth $9212. If you had invested $5000 initially and another $5000 today, you'd be looking at an investment with a market value of $9606. So by entering the market gradually, instead of all at once, you would have saved almost $400.

When It Works & When It Doesn't

In the illustrated example, our Dollar Cost Averaging approach outperforms our single lump-sum investment. That isn't always the case though and that's why I call my example "highly contrived." Let's look at what market conditions favour Dollar Cost Averaging and which favour a lump-sum investment.

Dollar Cost Averaging will work best when the markets go down before they go up. The longer they stay down and the lower they go before coming up, the better the Dollar Cost Averaging approach will perform compared to a lump-sum investment. As we already noticed in our illustrated example, the single purchase at $1 eventually led to a better overall result.

If the markets don't go down, or if they only go down a little before heading back up, then we'd be much better off with a single lump-sum investment. If the fund in our illustrated example above went from $3 to $4 and then to $5 without ever going down, then the Dollar Cost Averaging method wouldn't achieve anywhere near the same level of returns as the lump-sum investment.

So What Should You Do?

No one knows what the markets will do in the short term, so it's impossible to know which investment strategy would be best. So don't worry about the short term and don't try to time the market. Worry about the long term.

Regardless of whether Dollar Cost Averaging will result in better long term investment performance or not, setting up an automatic investment plan can be a great way to get started and stick with investing. Once it is set up, it removes the worry and decision making from the equation which is what stops most of us from ever investing in the first place!

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