The year is quickly coming to a close, and for many, it’s a time not only to take a step back and relax but also to receive work bonuses. Around this time of the year, many organizations give fringe benefits to their staff to mark the festivities.
Now, if you work at such an organization and do get an end-of-the-year bonus, one crucial question would be, “what would you do with that additional income?” Now you could:
- Spend it all celebrating with family and friends;
- Invest all that cash right away; or
- Expand your windfall and invest it over some time.
If you decide to go with the last option, you’ve chosen an investment strategy called Dollar Cost Averaging.
In this post, we’ll be discussing the following:
- What Dollar Cost Averaging is
- How Dollar Cost Averaging works
- The goal of Dollar-Cost Averaging
- Who are those involved in Dollar-Cost Averaging?
- When does Dollar Cost Averaging hurt?
What is Dollar Cost Averaging (DCA), and How does it Work?
Most markets go through various cycles. There is a time when the price of an asset increases (this is called a bull market) and when it decreases (called a bear market).
As a result of these price fluctuations, managing your investments can be challenging and emotionally draining. As such, only a few investors can make rational decisions when the market plunges.
However, dollar-cost averaging is a welcome choice for others who cannot manage the highs and lows of the market cycles.
Dollar-Cost Averaging (DCA) is a tool that investors use to build wealth over time. It is a system that helps to minimize the impact of short and long-term volatility.
With the DCA method, you can invest fixed amounts of money into an asset regularly. As a result, you’re not concerned or focused on the price fluctuations of the asset. Instead, you put in the stipulated amount at the specified time regardless of the rise and fall of the market.
For instance, rather than invest a lump sum of $20,000, you invest $2,000 every month for ten months. This is dollar-cost averaging.
The advantage of this investment strategy is that it has the potential to mitigate timing risk. As such, investors often opt for it when going for riskier investments such as mutual funds and stocks (as opposed to real estate or bonds).
It helps to manage risk and remove emotional stress from the equation while boosting the investment portfolio.
What is the Goal of Dollar-Cost Averaging?
The goal of dollar-cost averaging is to help you overcome the hassles of trying to time the market to decide the best investment time. It works to mitigate risk and minimize the effect of short and long-term volatility.
When trying to time the market, there’s a chance you’ll make mistakes and buy an asset at a higher price than necessary. But by using the DCA strategy, you can get rid of these complexities.
With DCA, you buy shares whether the price is high or low. The only thing that happens is that, since the amount you’re investing is fixed, you can only buy fewer shares of an asset when the price is high. And in the same vein, you get to purchase additional shares when the price is low.
This investment strategy is beneficial for Bitcoin and cryptocurrency investments as they are particularly volatile assets traded on the global markets.
Who are Those Involved in Dollar-Cost Averaging?
Dollar-Cost averaging is ideal for you if you:
- Have a retirement plan and are wondering how to invest your pension for a fixed period.
- Have monthly savings you’d like to invest.
- Are a new investor who either does not have a large amount of money to invest or don’t know where to begin. DCA is a hands-off approach that’s ideal for inexperienced investors.
- Are averse to risk.
When does Dollar Cost Averaging Hurt?
Despite the various advantages of DCA, this investment strategy is not without downsides. Some of the disadvantages include:
- Forfeiting potentially higher returns in a rising market. If the market goes up, you may miss the potential gains you could have had if you invested all your money at once.
- Paying additional brokerage fees which could reduce your profits.
- Experiencing feelings of regret if an investment is made immediately before a market decline.
The Bottom Line
Using DCA is a great way to invest without the hassle of market timing. It’s not all relaxation and fun, though. You still need to choose the right asset to invest in even when using this strategy.
Dollar-cost averaging or not, a bad investment will remain a bad investment.
Thankfully, the Art of Financial Planning is here to help. We can advise you on the best investments to dollar cost average and what other investment strategies to use to grow your wealth. Contact us today.
