Does the recent volatility of the stock market have you scared to log in to your investment accounts? If so, you’re not alone. To say it has been rough might be the understatement of the year.
With stocks swinging double digit percentage points on any given day, it begs the question: when do you pull the trigger on buying?
One approach that might help mitigate the anxiety of trying to time your purchases, is known as dollar-cost averaging (DCA).
DCA is a strategy where investors buy into a stock or index in equal amounts at regular intervals. For example, instead of investing $10,000 all at once into the market, you could instead invest $1,000 every month for 10 months .
Benefits of dollar-cost averaging
The obvious benefit of DCA is that it mitigates the risk of buying at the top right before a market crash. This is a real risk. If you had invested a lump sum into the S&P 500 in June of 2000, you would have had to wait over 12 years just to get back to even on your investment! Ouch.
Spreading out your purchases allows you to average into a position. Some buys might be great entry points, others might be at poor entry points. But in theory, your average cost basis over time will be attractive.
While that makes a lot of logical sense, arguably the greatest benefit of the DCA approach is that it allows you to invest without emotion.
My favorite line from Morgan Housel’s book The Psychology of Money: Timeless lessons on wealth, greed, and happiness is: “Napoleon’s definition of a military genius was, “The man who can do the average thing when all those around him are going crazy .”
The beauty of investing is you don’t need to do anything special. If you simply manage to make level-headed decisions while everyone else is making irrational and emotional ones, you are likely to outperform.
DCA gives you this ability.
Downsides of dollar-cost averaging
DCA is not a risk-free strategy. Perhaps the greatest risk is holding funds uninvested. Whether you’re holding a windfall (large sum like a bonus or inheritance) or you’re setting aside a portion of your paycheck each month, holding cash uninvested will underperform equities over time.
In fact a 2012 study conducted by Vanguard found that lump some investing outperformed DCA 67% of the time over a ten year period . A research team from Northwest Mutual also conducted a similar study and found that lump sum investing outperformed nearly 75% of the time according to the results published in 2021.
While it takes a lot of the decision making out of the equation, you certainly give up potential upside with the DCA strategy.
Conclusion: Know yourself as an investor
Investors will probably continue to debate which approach is the best until they are all blue in the face.
The reality is the best strategy is whatever allows you to make the smartest investing decisions. If you are highly affected by market volatility, then dollar-cost averaging into low-cost index funds might be your best approach. If you have a lot of control over your emotions when the market turns ugly, you might forego the DCA approach altogether and invest in lump sums when things look attractive.
Knowing how you react to market swings is crucial, and this might take several years to really know. Motley Fool Co-Founder David Gardner has eloquently described this as knowing your sleep number. In other words, what level of risk can you tolerate and still sleep soundly at night?
It took me years to learn how important this concept is for successful investing. You could be the greatest stock analyst on the planet, but if you can’t control your emotions when there’s “blood running in the streets,” you will never make money in the stock market.
Average investing over long periods of time produces better than average returns.
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