Dollar-Cost Averaging: a Bulwark against Emotional Decision-Making
Recently, Bank of America Merrill Lynch published data on cumulative flows (money movement) in equity and fixed income for their retail investor accounts, i.e., accounts not managed by an investment advisor.
As illustrated by the chart, since the beginning of the year, the investor-herd has been exiting the stock market (equities) and seeking safety in bonds (fixed income).
Meanwhile, the S&P 500 Index has looked like this since the beginning of the year - up 20.49% (YTD as of Sept. 7):
So was it a good strategy to exit the stock market? Or a fear-based reaction to high volatility, trade war tweets, and recession alarm bells? We believe it’s the latter.
So what is a good investment strategy in the face of so much stock market volatility?
Dollar cost averaging!
Dollar cost averaging (DCA) is an investment strategy where an investor buys the same dollar amount of an investment at regular intervals. For example, an investor buys $100 of mutual fund ARTIX every month, regardless of how high or low the price. DCA works because the number of shares bought varies with the price. With this strategy you have more shares purchased when the price is low and fewer shares purchased when the price is high. The result is a lower total average cost per share of the investment. Combined with that lower average cost per share, the investor also gets the power of compounding interest.
In contrast to dollar-cost averaging is another investment strategy called “buy the dip”. Buy the dip refers to an investor attempting to time the market and investing a lump sum of cash when they feel the market is down. (I say “feel” because study after study has shown that it is impossible to time the market correctly with any kind of consistency.) Everyone knows the adage buy low, sell high, so this approach seems to make some intuitive sense. Upon closer examination, though, dollar cost averaging beats buy the dip 97% of the time.
The downfall of this approach is that while you are waiting for the next dip, the market will keep rising and leave you behind. Unfortunately, this is what befell that herd of investors illustrated above, who exited the stock market for the bond market at the wrong time.
Individuals can use DCA in their 401(k)s, Roth IRAs, education accounts, or taxable savings accounts. Small business owners can start a retirement account like an individual 401(k), SEP IRA or SIMPLE IRA. The Propel team can setup a regular monthly deposit for you to make taking advantage of dollar-cost averaging a straightforward process. And, regular deposits are always easy to adjust if your cash-flow needs change.