Dollar-cost averaging is a simple investment method. Here’s how it works: you invest the same amount of money in the same portfolio, at regular intervals (weekly, monthly or quarterly) regardless of fluctuations in price, over a long time span.
Let’s say you’re able to save around 100 euros each month. You decide to invest it in an all-world stock index, hoping to retire more comfortably in 30 years. Using dollar-cost averaging simply means you invest those 100 euros (not 95, not 110: always 100 euros) each month in the same index, regardless of its price going up or down.
Since you always invest the same amount, when the price of the index increases, you buy fewer shares of it, but when it decreases you will be able to buy more at a lower cost. This evens out the average cost of your investment and protects it from large market swings, helping you build up wealth over time.
Of course, in order to make money, the price of your investment needs to go up eventually, so this method only works with assets you are fairly sure will see grow over the long run. We’ll touch upon that in a sec.
Dollar-cost averaging is not really an investment strategy per se; it is one of the two possible methods to implement a strategy called ‘buy-and-hold.’
Buy-and-hold is the simplest and most effective strategy to invest in the long run. It works like this: you define a well-diversified portfolio made of different asset classes like stocks, bonds, gold, cryptocurrencies, etc. Then you decide how much of your capital you want to allocate to each of them based on your risk propensity, and then you stick with this portfolio for the whole duration of the investment, independent of the ups and downs of the markets.
This is a passive strategy, which means that it passively tracks the market over a long-time period without trying to actively pick the right time to buy and sell assets.
It is built on the assumption that, in the long run, global stock markets tend to go up. Such an assumption is based on historical evidence. The main factors driving this tendency are population growth, which increases the demand for goods and services, and technological innovation, which makes companies more productive. In the long run, the combination of these two forces tends to increase company profits and valuations accordingly.
Therefore, following this assumption, if you hold a diversified stock portfolio long enough, you should end up with a profit. This makes buy-and-hold an effective strategy in the long term, even though it doesn’t ensure that it will work on shorter periods of time, over which returns can be significantly affected by volatility.
Now, as I said, dollar-cost averaging is simply one way of implementing the buy-and-hold strategy. In fact, there are basically two ways you can implement it: either dollar-cost average or, if you have a lump sum to invest, you can invest it all together. Both of these approaches have advantages and disadvantages.
If you have a sum at your disposal, you can decide to invest it all together. In theory, this would be the best approach, because it gives your entire capital more time to grow and it maximises the compound interest your investment can generate through the reinvestment of dividends and coupons.
On the other hand, imagine doing this at the tip of a market bubble. Seeing your portfolio crash right after you invest and not recover for years may be taxing on an emotional level. That’s why, even if you have a sum to invest all at once, you may decide to dilute your investment over time through dollar-cost averaging, sacrificing part of the potential returns for some more peace of mind and liquidity.
Therefore, on an emotional level, many investors prefer to use dollar-cost averaging. When prices climb, you’ll be happy to see your portfolio grow, when they drop, you’ll see it as an opportunity to buy more of it at a discount.
To sum it up, dollar-cost averaging shows at least three great benefits:
It is simple to apply because you don’t have to try and predict the market. You only have to choose the fixed sum you’ll invest each time and the frequency of your installments; then you just stick to the plan. This is the hardest part, but (beware!) it is crucial for it to work. If the market keeps on sliding or crashing, you could be tempted to skip your monthly installment, feeling like you’re throwing your money in an endless pit. That’s the biggest mistake you can make and it will hinder your results.
It protects you from your own emotions. Sticking to the plan without caring about the price will prevent you from making mistakes triggered by emotion, which commonly affect the performance of active traders and investors.
As said, dollar-cost averaging protects your investment from large market swings.
Of course, it has some cons as well. Two in particular:
Compared to lump-sum investing, it usually provides slightly lower returns. So if you already have the money to invest and you can ride out any short-term volatility, go for lump-sum investing. If you don’t have the money or you’re nervous about your investment being underwater for a while, dollar-cost averaging might be a better fit for you.
Depending on how high the transaction fees that your broker charges are, dollar-cost averaging can be more expensive than lump-sum investing, because it implies many transactions. Fortunately, with BUX Zero you can buy and sell stocks and ETFs on global indices with zero commission.
‘‘All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.’’