Is dollar cost averaging better than investing a lump sum in volatile markets?

How should investors manage wild swings in stock markets? Investing is never easy, especially during one of the most volatile years in stock market history. Whether you have extra money on the sidelines or are questioning your investment strategy, it’s easy to let hindsight bias or fear of losing money sway your decisions. Especially when Investing during a recession or economic downturn, dollar cost averaging can be a powerful tool to reduce the risk – and fear – of investing at the wrong time.

As opposed to trying to time the market, where you speculate on the most opportune time to buy or sell, when you invest money in the market on average, you buy at set intervals, regardless of what the market is doing on that particular day does .

How dollar cost average works

Dollar cost averaging helps minimize the impact of volatility when investing because contributions are spread out over time rather than being invested as a lump sum.

As you can see, the price fluctuations on the stock exchange can be extreme and sometimes deviate significantly from the return over the entire calendar year. But unless you invest on January 1stStYour annualized performance can be much better – or worse – than the index itself, depending on when you invest.

Daily returns for the S&P 500 compared to calendar year returns

Example of using dollar cost average for investing in volatile markets

Let’s say you have $50,000 to invest at the beginning of the year. Instead of investing it as a lump sum, opt for the dollar-cost average instead.

You invest $10,000 per month on the 20thth day of the month or the next day the market is open. For the sake of simplicity, let’s assume you only buy shares of SPY, the SPDR S&P 500 ETF (in practice, you should think about it Investments outside of the S&P 500 to diversify). Until May 20ththyour schedule for purchases would look like this:

When the stock price is at its highest in January and February, buy fewer stocks with your investment. During the March lows, you bought nearly 50% more stock with the same $10,000 investment!

If you put $50,000 on the market all at once in January, you would have 150 shares. A lump sum investment in March would yield 218 shares. But in January you didn’t know the downturn was coming – and in March you probably feared the sell-off would continue and might decide to do so wait it out in cash. You probably didn’t think the market would rise 37% in 58 days.

By using the dollar cost average, you have helped smooth out the effects of price volatility. Over the course of five months, you were able to buy 173 shares at an average price per share of $295.

An extraordinary example of an extraordinary time

If the price fluctuations in the previous example seem significant, that’s because they are. So far, 2020 is shaping up to be one of the most volatile years for the financial markets, albeit How 2020 compares to past recessions and bear markets. Almost 25% of all trading days resulted in price fluctuations of 3% or more for the S&P 500, and March was the most volatile month in the index’s history, averaging 5% daily fluctuations.

The fastest bear market in history (so far) has resulted in an equally impressive rebound. This shows the benefits dollar cost average can offer, especially in volatile markets. It also highlights some of the limitations.

Hindsight bias is always there

Especially in volatile markets, the dollar cost average can help investors avoid large short-term losses on paper, as if they had invested all their money at once on a random “wrong” day. You won’t benefit from a full investment if you happen to be investing at the bottom of the market, but you could also avoid buying all of your stocks at the top only to plunge into a bear market.

Since we only know the best time to invest in hindsight, the dollar cost averaging method helps reduce the risk of an extreme outcome, be it positive or negative.

Dollar-Cost-Average makes it easier to stick to the plan

The reality is that many investors are reluctant to invest more when the market is down. When everyone is selling and there is tremendous uncertainty, it’s difficult to behave bucking the trend. With hindsight, after the market has rallied, investors often regret not taking what they now know to be a great buying opportunity.

Dollar cost averaging by investing a fixed amount at set intervals can help investors stick to the plan without second-guessing their decisions or getting too emotional when market conditions change. This strategy can help investors not hold cash instead of investing and miss out on the market rally.

Dollar cost average vs. investing a lump sum

There isn’t always one perfect way to invest money. Dollar cost averaging can help reduce the impact of short-term price fluctuations, but there’s only so much you can do planning a market crash.

One of the downsides of dollar cost averaging is the opportunity cost of holding on extra money. Especially if you plan to invest cash for a long period of time, you’re likely to miss out on dividends and income over that period.

An avant-garde learn has actually shown that investing a lump sum outperforms dollar costs 64% of the time over six months and 92% of the time over 36 months, assuming a 60%/40% portfolio of stocks and bonds. As with any study, there are important parameters to consider. For example, in the analysis, the money was invested for 12 months, which is not a short time.

Why? The market tends to rise more than it falls. The pandemic has just ended the longest bull market in history. If you had an average dollar cost in the final months of 2019 instead of early 2020, you probably would have bought the $10,000 investment always less shares every month. Which poses another risk: that the market will only go high during your investment period.

Distribution of US stock market returns

CRSP 1-10 index returns through the year 1926-2019

So why discuss the benefits of dollar-cost-average when research says otherwise? Because all too often, investors downplay the behavioral aspects of investing until they are faced with a big decision that involves risk. So if the thought of putting all your money in the market at once seems too stressful to you – don’t do it! Dollar cost averaging can help individuals sleep at night and avoid making anxiety-driven decisions about whether to invest at all.

Time in the Market about timing of the market

The stock market is not a place to invest for quick returns. While the dollar cost average can help reduce the short-term impact of price fluctuations on your performance, consider focusing instead on the long-term goals you’re investing for.

Time in the market is better than long-term market timing, and history shows that the longer you stay invested in the stock market, the better your chances of making money.

Investing in extreme market conditions is difficult, and cost-averaging analysis helps investors stick to their plan when they have capital to deploy. Whether you choose to invest for a lump sum or for a longer period of time, don’t try to quarter your decision on Monday morning. Hindsight is always 20/20.

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