Take the Guesswork Out of Investing in Volatile Markets

It's tough to be an investor these days when the stock market is so volatile and likely to remain so for some time.

What if you jump in and then your shares plunge days later? Or, say you decide to sit on the sidelines waiting for the right time to invest. How will you know when that is? Precisely timing the market is almost never successful — even by financial professionals. Guess wrong and you could miss out on some of the market's best days. (See this brief video about how you can control your emotions during market volatility.)

But there's a simple strategy that can eliminate the guesswork of when to invest during volatile markets or recessions: dollar-cost averaging.¹ Basically, it works like this:

• You invest a fixed amount at regular intervals; say, the first trading day of each month, no matter what's happening in the market.
• When stock or fund prices are high, you will end up purchasing fewer shares.
• When prices fall, you will buy more shares. (You are already dollar-cost averaging if you regularly invest in a workplace retirement plan through payroll deductions.)

Leveling the peaks and valleys

Consider this example of someone with $2,400 to invest. If she invested all the money at once in January when the price was $30 per share, she would own 80 shares. If instead she made equal purchases spread out over four months — when the price ranged from $20 to $40 per share — she would end up with 90 shares at an average price of $26.67 per share. This is shown in the chart below.

 

Over time, dollar-cost-averaging smooths out the wide swings. Learn more about this concept.

And the strategy doesn't only work when buying securities. It can also eliminate guesswork on when to sell, too. 

Ideally, you sell shares when they are at a high point, although you can't know for sure when that will occur. So instead of offloading your securities all at once — and risking that the price continues to climb after the sale — you can sell equal amounts over a set period. For example, if you have $50,000 in stock to trade, you can sell $10,000 of shares each week or month —eliminating the risk that you are selling your entire investment on the worst possible day.

Dollar-cost-averaging, however, doesn't guarantee you the highest return over time. Investing a lump sum — and quickly putting your money to work in the market —  may outperform dollar-cost averaging during bull markets. Likewise, investing a lump sum may underperform dollar-cost averaging during bear markets.

But dollar-cost-averaging protects us against one of our worst investor instincts, namely, the temptation to time the market.

Avoiding the panic reactions

The average investor does a poor job of market timing, according to investor behavior studies by Dalbar, a financial services market research firm. For example, in 2018 — another volatile year for stocks — many investors took money out of the market when stocks headed downward, Dalbar says. But that meant they were also not in the market in the months when stocks rebounded. For the year, the average stock fund investor lost 9.42%, compared with a 4.38% drop in the S&P 500 index. Think about that — poor timing caused the average investor to lose about double the actual market loss.

Dollar-cost averaging is sometimes abbreviated to DCA and the “D” could also stand for “discipline.” The strategy provides the discipline investors need to stay invested and to avoid panicking during volatile markets. And it's that discipline that will help investors reach their long-term goals.

¹ Dollar-cost averaging does not assure profit or protect against loss in a declining market. Since it involves continuous investment, investors must consider their ability to continue to invest during low price levels.