Advice & Research
David Furst, Advice Strategy
December 2020 | Portfolio Perspectives
Indecisive? … Try Dollar Cost Averaging
Let’s imagine a hypothetical investor, Joanne, who has available funds to invest into her portfolio. She has been keeping an eye on a stock to purchase for a while now, yet the price continues to rise. As the market appreciates, a few weeks have passed and she is still hesitant about when to make an investment. As she anxiously waits to buy at a dip in the market, her decision paralysis causes her to feel indecisive.
She calls her financial advisor to ask, “When is the best time for me to enter the market?” Joanne’s advisor reminds her, it is almost impossible for anyone to perfectly time the market. He recommends a disciplined investment strategy of dollar cost averaging: the process of investing a fixed dollar amount on a set schedule. Instead of continuing to hold cash, she will be able to ease into the market with a goal of minimizing her decision paralysis and market timing risk associated with a large lump-sum investment.
Dollar Cost Averaging
With the ultimate goal to “buy low and sell high”, most investors find it difficult to predict how the market will move in the future. Dollar cost averaging can help you avoid an unfavorably timed, lump-sum decision with a fixed investment schedule. By spreading out a large investment into smaller quantities, you can help reduce market timing risk.
It is not too late to begin investing or to utilize a strategy. You have the ability to control your financial decisions while lowering stress. Both beginning and experienced investors can deploy this technique into their financial plans to help build savings and generate wealth.
In order to begin, there are three up-front decisions: the amount, frequency (i.e. weekly, monthly, and quarterly), and location of the investment. For example, investing $100 each month or $500 every 3 months into your portfolio.
Dollar cost averaging can be incorporated into a variety of investments, including regular contributions into retirement accounts, like an IRA or 401(k) plan, saving a percentage of your monthly paycheck, and increasing other investment positions. You may already be effectively implementing this strategy with automatic contributions set up for a 401(k) plan.
It is important to keep a cash account with 3-6 months of living expenses for emergencies. If you have available funds outside of your cash “cushion”, consider putting them to work with dollar cost averaging. These available funds are often referred to as “sidelined funds”. Long-term market opportunities can be achieved when you are in the market and not on the sidelines.
FOMO: Fear of Missing Out
The opposite of decision paralysis is FOMO: the fear of missing out. FOMO is the fear of not being included in something that others are experiencing, creating a sense of urgency to be included. While hesitancy creates decision paralysis and the indecisiveness of when to invest, FOMO drives the desire to enter the market as soon as possible. It is the fear of missing out on potential market gains.
Let’s consider a hypothetical investor, Carl, to understand his FOMO. Carl checks the internet multiple times a day to stay informed with the latest news, market trends, and investment topics. His fear of missing out on recent strategies motivates him to invest, while it also causes him to act too fast at times.
Carl is ready to make an investment. Before he makes a quick decision to invest a lump-sum amount, he remembers reading about the strategy he wanted to implement: dollar cost averaging. By investing on a set schedule, he will be able to enter the market at a steady rate and help accommodate his FOMO.
In order to begin, he decides how much, how often, and where to allocate his available funds. Carl holds a long-term investment horizon and plans to invest a fixed dollar amount of $400 into a fund on a monthly basis. To illustrate, let’s examine his monthly investments during a period of volatility.
After one year, Carl invested a total of $4,800 with an average purchase price of $36.33. He was able to purchase more shares when the prices fell in Month 1 and fewer shares when the prices rose in Month 6, benefitting him with a lower average cost per share of $34.89. By consistently investing on a monthly schedule, Carl was able to focus on asset accumulation, while helping to reduce the risk of a large lump-sum investment.
Dollar cost averaging can be effective in both rising and falling markets. By purchasing more shares at lower prices and fewer shares at higher price, this diversification of purchase prices helps minimize market timing risk over the long-term.
Time is your Ally
With a long-term investment horizon, time in the market can be your ally. Dollar cost averaging can help achieve time IN the market rather than tim-ING the market.
Investing on a regular schedule can have a powerful impact for long-term growth potential. Volatility is a normal part of market behavior and by remaining invested during turbulent times, you are able to recover losses following bear markets and profit during bull runs. During market fluctuations, dollar cost averaging presents the opportunity to buy more shares when prices are down. It is important to take advantage of down days and periods of volatility to put sidelined funds into the market for long-term opportunities.
Market Timing Risk
With all types of investments, there comes a certain level of risk. Dollar cost averaging aims to reduce market timing risk and accommodate your fear of missing out. Investors’ decisions, behaviors, and emotions can all be impacted when market volatility increases, making it difficult to pinpoint the best time to invest.
Dollar cost averaging does not guarantee a fixed rate of return or protect from loss. This strategy overlooks day-to-day market fluctuations; therefore, purchases will be made when the market is up and down. It is important to research where you plan to place your investable assets and discuss strategies with your financial advisor. Market downturns can be difficult to endure, but by remaining fully invested, you can help position your portfolio for long-term success and incrementally accumulate more shares with a dollar cost averaging investment schedule.
The goal is to stick to a long-term schedule of periodic purchases to reduce the fear of not buying or selling at the “right” time. By diversifying the time and purchase price of fixed investments, this attractive feature of dollar cost averaging can help make investing less intimidating. If you have investable money, you can use dollar cost averaging to allocate your sidelined funds into the market.
Contact your financial advisor to see if this disciplined approach can be implemented into your financial plan.
Index return information is provided for illustrative purposes only. Index returns do not represent investment returns or the results of actual trading nor are they forecasts of expected gains or losses a fund might experience. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Past performance does not guarantee future results.
IMPORTANT: The projections or other information generated by Envision regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Results may vary with each use and over time. This information is made available with the understanding that Wells Fargo Advisors and its affiliates are not engaged in rendering legal, accounting, or tax advice.
Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.
Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.