There are two predominant schools of thought about the stock market. The views of these schools of thought are somewhat contradictory.
There is one school of thought which advises investors to stay away from stock market investments since they are inherently volatile. You will often see people who believe in this school of thought advocating that people stay away from stock markets due to the volatility that is inbuilt in the market.
The second school of thought, on the other hand, encourages people to invest in the stock market. This is because they focus on the returns and state that, in the long term, there is no other investment class that has given as much returns as the stock markets.
The end result is that investors are often torn between whether to invest in the stock market or to stay away from the volatility. This is when a method called dollar-cost averaging was created to reconcile the two approaches. This approach assists in reducing the volatility of the stock market while helping the investors gain the benefits of maximum returns.
In this article, we will have a closer look at what dollar-cost averaging is and what are some of the benefits which are associated with dollar-cost averaging.
What is Dollar-Cost Averaging?
Dollar-cost averaging is an investment strategy that has been created in order to reduce the volatility of the stock markets. The idea behind dollar-cost averaging is very simple. In fact, it is so simple that it doesnt sound like a sophisticated strategy, which is why many investors doubt whether it will work. However, over the years, it has proved to be effective.
The idea behind dollar-cost averaging is that the volatility in the stock market exists because people try to time the market. This means that they try to look for one singly entry point to an investment. The search for that perfect entry point often leads them to make a lot of wrong decisions. Sometimes, they buy when the market is very high. Other times, they dont buy enough when the market is low.
Dollar-cost averaging aims to remove the emotional component of investing and replace with a mechanical component. Hence, an investor following a dollar-cost averaging is not supposed to consider any external details. They have to blindly invest a given sum of money on a given date every month regardless of whatever the market circumstances are!
We can understand this with the help of an example. Lets say an investor is supposed to invest $1000 at the beginning of every month in the stock market. It is important to understand that the date of investment, as well as the amount, should be constant. If these variables change, then the person is not following dollar-cost averaging. The reasons why this investment approach works have been written below:
Why Does Dollar Cost Averaging Work?
- Discipline: The most important reason for the success of this investment approach is that it has built in discipline. Most people do not invest successfully because they dont invest at all. The dollar-cost averaging ensures that a person is duty-bound to invest the exact same sum of money every month. It has been observed that people on dollar-cost averaging plans end up investing significantly more money as compared to those who are not on such plans.
- Automatic Adjustment: The dollar-cost averaging plan has a built-in regulating mechanism. Since the amount to be invested is the same each month, then the number of units purchased varies solely based upon the price. As a result, when the price goes higher, automatically, the number of units purchased becomes less. At the same time, when the price goes lower, the number of units purchased automatically becomes more. As a result of this strategy, investors do not have to worry about timing the market. By following the simple strategy, they eliminate two important decisions, i.e., when to invest and how much to invest.
- Time Diversification: The most important feature of dollar-cost averaging is that it provides time diversification to investors. Instead of investing all their money in a lump sum at one point in time, the investor puts their money in at several different points. Market bubbles only exist for short periods of time. The risk that an investor faces is that they might be buying into those bubbles. However, when dollar-cost averaging is followed, purchases are spread out over large periods of time. This virtually eliminates the possibility of buying at a very high price point.
- Stock Diversification: People following a dollar-cost averaging often do not invest their money in single stocks. Instead, they take the cover of low-cost mutual funds to do so. Hence, the dollar-cost averaging strategy reduces its exposure to a single stock as well. This also builds in diversification and reduces the possibility of making risky investments.
- Reduces Emotional Responses: Most importantly, the dollar cost averaging plan prevents the investor from making emotional decisions. Investors on this plan are no longer driven by greed and fear, which causes investors to make irrational decisions and lose their money. Instead, they are driven by a time tested system of making investments that spreads out the risks and virtually guarantees success in the long run.
The dollar-cost averaging technique was first popularized by author and financial planner David Chilton in his famous book, The Wealthy Barber. Ever since it has formed the basis of many financial plans, nowadays, the approach is so popular that there are tools called Systematic Investment Plans which have been created keeping the dollar-cost averaging principle in mind.
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