Methodology

Stocks

Module 4

Dollar-cost averaging

An investor that follows a strategy of dollar-cost averaging simply invests into the market on a regular basis.

The investor would decide how much they are willing to invest into their stocks, most commonly on a monthly basis. For example, an investor following this strategy may decide to invest $100 a month, every month. 

The benefit of dollar-cost averaging is that the investor can take advantage of a range of prices – they can invest when prices are both low and high. This results in an average investment price that is lower than just investing all of their money at once.  

Ideally, it would be best if the investor allocated more money than usual to their regular investments when stock prices are low. This will enable them to reduce the average price that they have previously bought stock at, making it easier for them to make a gain as prices rise again.

The stock market is often unpredictable and investors can make mistakes with timing, but dollar-cost averaging reduces these risks as investments are made regularly, regardless of whether prices are thought to be low or high.  

A key drawback of dollar cost averaging

An important consideration to note about dollar cost averaging is that it only works if the stock price of a company rises over time.

There is nothing to say that dollar cost averaging will bring investment success, it simply allows you to take advantage of a range of prices, lowering the average price that you own stocks at.

For instance, if you buy 1 stock at $10 and another stock a month later at $5, your average stock price would be $7.50. This would be beneficial if the stock price returned to $10, with a $2.50 profit being achieved.

At the same time, if the stock price continues to tank down to $3 a share, dollar cost averaging would provide no real benefit.

Therefore, dollar cost averaging must be used alongside other investment strategies to be more effective.

Furthermore, it is important to not set your regular investment amount at such a low figure. This is because transaction fees (usually around $10 per trade) will put you in a negative position to start from. For example, investing $100 a month would put you in a starting position of -10%, if transaction fees were to be around $10 per trade.

Dollar cost averaging and investor psychology

A useful benefit of dollar-cost averaging is that it can enable the investor to reduce their anxiety over changes in the stock market.

Naturally, investors worry about the stock market going down, as they fear making a loss. However, dollar cost averaging makes a declining stock market to be more of a positive thing for investors, as they can think of it as getting a bargain, rather than making a loss.

In addition, thinking of their positions in stocks as an average, helps investors to feel that they have more control over their investments.

It removes the need to have perfect timing in the market and stops investors from making decisions that are informed by their own fear or greed.

Instead, investors are committed to investing the same amount of money over a certain frequency of time, regardless of whether the market is performing well or not.

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