Investors who want more discipline in reaching their savings goals can benefit from dollar-cost averaging.
Dollar-cost averaging can lead to more consistent savings over time as money earmarked for savings is taken out before it’s spent on other items.
There are numerous benefits to this investment strategy versus lump-sum saving — as sometimes people who try to invest using a lump-sum approach have a harder time reaching their savings goals because they focus on saving last, not first.
What Is Dollar-Cost Averaging?
Investors who use dollar-cost averaging to save create consistent intervals to fund their financial accounts. This strategy can be biweekly, monthly, quarterly or on any other time frame suitable for the investor, says Robert Wyrick, chief investment officer at Post Oak Private Wealth Advisors.
It’s important to not confuse dollar-cost averaging with market timing, and it’s also important to leave the investing on autopilot, Wyrick says. He explains that sometimes he’ll hear people say they want to dollar-cost average, but then they override their predetermined investing dates based on what the market is doing.
“That becomes an exercise in timing, which is difficult to do successfully,” he says, which is why it’s important to stick to set days to invest — such as the 15th and 30th of the month.
Bryan Bibbo, lead advisor with The JL Smith Group, concurs that consistency also helps to avoid market timing. “People shouldn’t try to time the market. It’s like catching a falling knife,” he says. “Are you going to catch it on the handle perfectly? Are you going catch it on the blade and get cut?”
With this in mind, here are three ways a dollar-cost averaging strategy can help investors:
— Dollar-cost averaging smooths out costs.
— Dollar-cost averaging eases the emotional impact of investing.
— Dollar-cost averaging can help rebalance portfolios.
Dollar-Cost Averaging Smooths Out Costs
Bibbo says he employs the dollar-cost averaging strategy with clients who are rolling over 401(k)s from previous jobs or other accounts. He says this is a prudent move during stock market volatility.
“What I’ve been personally doing with clients is instead of taking their money and plugging it right into the market, we are dollar-cost averaging over a six-to-12-month period,” Bibbo says, noting that gradually adding money helps to smooth out transitioning the retirement portfolio.
This dollar-cost averaging formula works in the short and long term, Wyrick says. For example, if a person has $100 and wants to dollar-cost average into a stock, a mutual fund or exchange-traded fund that initially costs $10 a share, they’re able to buy 10 shares. If the price falls sharply and is now $5 a share, the investor can buy twice as many shares with that $100.
“It really averages out, especially over many years,” he says, which is why this way of buying is beneficial for 401(k) participants.
He says even on a shorter-term basis it’s helpful. For example, if an investor is trying to allocate money over the next six months, because of the current volatility, “you really do end up getting a much smoother cost basis.”
Dollar-Cost Averaging Eases the Emotional Impact of Investing
Dollar-cost averaging helps to lessen the emotional impact of the market’s volatility by creating a consistent investing pattern. “When the market goes down, people are fearful. And when the market sets new highs, people are usually euphoric,” Bibbo says.
But when investors buy based on planned intervals, whether it’s every two weeks or once a month, such as in a 401(k) timed with paychecks, they are buying no matter where prices are at the time. Not only does that eliminate the fearfulness of worrying that prices will continue to fall if an investor buys during market dips, it also curbs the exuberance that you may have during market rallies, he says.
Dollar-Cost Averaging Can Help Rebalance Portfolios
Michael Kayes, managing director of investments at Exencial Wealth Advisors, is also a fan of dollar-cost averaging to rebalance or take profits on winning positions.
Dollar-cost averaging to sell some investments that have made money is also known as “scaling out of a position,” especially for investors who trade in taxable accounts. Just as investors may have plans in place to dollar-cost average when buying a stock, known as “scaling in,” they should have a plan for when they are ready to take profits.
Kayes says a common time to scale out or rebalance a holding is when it occupies an overweight position in a portfolio. For example, an investor may put a 10% weighting limit on any one holding in their portfolio. If a holding exceeds the 10% threshold, they could systematically sell enough to rebalance the position back to under the limit.
“You’re not selling the whole thing; you’re easing your way out. That to me has always been a good rule,” he says.
John Person, founder of Persons Planet, a trading education and advisory service company, says dollar-cost averaging is a good way to move out of one position to another. “It keeps you from not being locked into stocks that might not be performing well,” he says. “Walgreens was a household favorite name, but someone might see exciting new opportunities in something like Zoom.”
He says while Walgreens Boots Alliance (ticker: WBA) pays a 5% dividend, the stock’s price has seen little appreciation. If an investor wanted to buy a stock such as Zoom Video Communications ( ZM) but didn’t have any extra cash, “there’s nothing wrong with taking a partial position of one stock to enter into another longer-term trade over time. That’s called asset reallocation,” he says. “And that’s an opportunity.”
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