Log In

Reset Password

Dollar-cost averaging can smooth your costs

Look for the embedded question in this article for the BSX WIW Quiz Challenge

This article is the third of six pieces, published between October 2 and 7, in support of the Bermuda Stock Exchange World Investor Week Quiz Challenge. Each article has a question embedded. Find the question and send your answer to wiwqc@bsx.com. Those with six correct answers will be entered into a draw to win a grand prize of a $2,500 Bermuda securities portfolio.

Dollar-cost averaging is the strategy of spreading out your stock or fund purchases, buying at regular intervals and in roughly equal amounts. So instead of buying stock in a single large purchase, you invest that same amount over a year or two years or even indefinitely, by regularly adding money to the market.

When done properly, dollar-cost averaging can have significant benefits for your portfolio. This is because the strategy “smooths” your purchase price over time and helps ensure that you’re not dumping all your money in at a high point for prices.

Dollar-cost averaging can be especially powerful in a bear market, allowing you to “buy the dips,” or purchase stock at low points when most investors are too afraid to buy. Committing to this strategy means that you will be investing when the market or a stock is down, and that’s when investors score the best deals.

Here are a few scenarios that illustrate how dollar-cost averaging works.

Scenario 1: Lump-sum purchase

First, let’s see what happens with a $10,000 lump-sum purchase of ABCD stock at $50, netting 200 shares. Let’s assume the stock reaches the following prices when you want to sell and the gross profit or loss.

At $40, the loss would be -$2,000.

At $60, the profit would be $2,000

At $80, the profit would be $6,000

This is the baseline scenario. Now let’s compare it with others to see how dollar-cost averaging works.

Scenario 2: A falling market

Here is where dollar-cost averaging really shines. Let’s assume that $10,000 is split equally among four purchases at prices of $50, $40, $30 and $25 over the course of a year. Those four $2,500 purchases will buy 295.8 shares, a substantial increase over the lump-sum purchase. Let’s look at the profit at those same sell prices again.

At $40, the loss would be -$1,832.

At $60, the profit would be $7,748.

At $80, the profit would be $13,664.

With dollar-cost averaging, you actually have an overall gain at $40 per share of ABCD stock, below where you first started buying the stock. Because you own more shares than in a lump-sum purchase, your investment grows more quickly as the stock’s price goes up, with your total profit at an $80 sale price more than doubled.

Scenario 3: In a flattish market

Here’s how dollar-cost averaging performs in a market that’s going mostly sideways, with a few ups and downs. Let’s assume that $10,000 is split equally among four purchases at prices of $50, $40, $60 and $55 over the course of a year. Those four purchases will get 199.6 shares, basically what a lump-sum purchase would get. So the pay-off profile looks nearly identical to the first scenario, and you’re not much better or worse off.

This scenario looks equivalent to the lump-sum purchase, but it really isn’t, because you’ve eliminated the risk of mistiming the market at minimal cost. Markets and stocks can often move sideways — up and down, but ending where they began — for long periods. However, you’ll never be able to consistently predict where the market is heading.

In this example, the investor takes advantage of lower prices when they’re available by dollar-cost averaging, even if that means paying higher costs later. If the stock had moved even lower, instead of higher, dollar-cost averaging would have allowed an even larger profit. Buying the dips is tremendously important to securing stronger long-term returns.

Scenario 4: In a rising market

In this final scenario, let’s assume the same $10,000 is split in four instalments at prices of $50, $65, $70, and $80, as the market rises. These purchases would net you 155.4 shares. Here’s the pay-off profile.

At $40, the loss would be -$3,782.

At $60, the loss would be -$676.

At $80, the profit would be $2,432.

This is the one scenario where dollar-cost averaging appears weak, at least in the short term. The stock moves higher and then keeps moving higher, so dollar-cost averaging keeps you from maximising your gains, relative to a lump-sum purchase.

But unless you’re trying to turn a short-term profit, this is a scenario that rarely plays out in real life. Stocks are volatile. Even great long-term stocks move down sometimes, and you could begin dollar-cost averaging at these new lower prices and take advantage of that dip. So if you’re investing for the long term, don’t be afraid to spread out your purchases, even if that means you pay more at certain points down the road.

Benefits of dollar-cost averaging

Dollar-cost averaging provides three key benefits that can result in better returns. It can help you:

• Avoid mistiming the market.

• Take emotion out of investing

• Think longer term.

In other words, dollar-cost averaging saves investors from their psychological biases. Because investors swing between fear and greed, they are prone to making emotional trading decisions as the market gyrates.

However, if you’re dollar-cost averaging, you’ll be buying when people are selling fearfully, scoring a nice price and setting yourself up for strong long-term gains. The market tends to go up over time, and dollar-cost averaging can help you recognise that a bear market is a great long-term opportunity, rather than a threat.

Name the great investor who famously said: “Be fearful when others are greedy. Be greedy when others are fearful.”

Drawbacks of dollar-cost averaging

The two downsides of dollar-cost averaging are modest. First, buying more frequently adds to trading costs. However, with brokerages charging ever less to trade, this expense becomes more manageable. Moreover, if you’re investing longer term, fees should become very small relative to your overall portfolio. You’re buying for the long haul, not trading in and out of the market.

Second, by dollar-cost averaging, you may forgo gains that you otherwise would have earned if you had invested in a lump-sum purchase and the stock rises. However, the success of that large purchase relies on timing the market correctly, and investors are notoriously terrible at predicting short-term movement of a stock or the market.

If a stock does move lower in the near term, dollar-cost averaging means you should come out way ahead of a lump-sum purchase if the stock moves back up.

How to start dollar-cost averaging

With a little legwork upfront, you can make dollar-cost averaging as easy. In fact, you may already be dollar-cost averaging if you’re contributing regularly to a pension fund at your workplace. Setting up a plan with most brokerages isn’t hard, though you’ll have to select which stock — or ideally, which well-diversified exchange-traded fund — you’ll purchase.

Then you can instruct your brokerage to set up a plan to buy automatically at regular intervals. Even if your brokerage account doesn’t offer an automatic trading plan, you can set up your own purchases on a fixed schedule — say, the first Monday of the month.

You can suspend the investments if you need to, though the point here is to keep investing regularly, regardless of stock prices and market anxieties. Remember, bear markets are an opportunity when it comes to dollar-cost averaging.

Here’s one final trick to add a little extra juice to dollar-cost averaging: many stocks and funds pay dividends, and you can often instruct a brokerage to reinvest those dividends automatically. That helps you continue to buy the stock and compound your gains over time.

For more information about the BSX WIW Quiz Challenge, see the PDF attached to this story online at www.royalgazette.com or go to www.bsx.com

James Royal, PhD, is a staff writer at NerdWallet, a personal finance website at www.nerdwallet.com. His e-mail is jroyal@nerdwallet.com Twitter: @JimRoyalPhD