How should investors navigate wild swings in the stock market? Investing is never easy, especially during one of the most volatile years in the stock market’s history. Whether you have extra cash sitting on the sidelines or are second-guessing your investment strategy, it’s easy to let hindsight bias or a fear of losing money impact your decisions. Especially when investing during a recession or economic crisis, dollar-cost averaging can be an effective way to reduce the risk—and fear—of investing at the wrong time.
Unlike trying to time the market, where you speculate the most opportune time to buy or sell, when you dollar-cost average money into the market, you’re buying at predetermined intervals, without regard to what the market is doing on that particular day.
How dollar-cost averaging works
Dollar-cost averaging helps minimize the impact of volatility when investing as contributions are spread over time instead of invested as a lump sum.
As you can see, the price swings in the stock market can be extreme and sometimes vary significantly from the return over the whole calendar year. But unless you’re investing on January 1st, your annualized performance may be much better—or worse—than the index itself depending on when you invest.
Example of using dollar-cost averaging to invest during volatile markets
Assume you have $50,000 to invest at the beginning of the year. Rather than invest it as a lump sum, you decide to dollar-cost average instead.
You invest $10,000 per month on the 20th day of the month, or on the next day the market is open. For simplicity, let’s just assume you’re only buying shares of an S&P 500 ETF (in practice, you’ll want to consider investing outside of the S&P 500 to diversify). By May 20th, your schedule of buys would look as follows:
When the share price is the highest in January and February, your investment buys you fewer shares. During the March lows, the same $10,000 fixed investment bought you nearly 50% more shares!
If you put $50,000 in the market in January all at once, you’d have 150 shares. A lump sum investment in March would yield 218 shares. But in January, you don’t know the downturn is coming—and in March, you were probably afraid the selloff would continue and may decide to wait it out in cash. You probably wouldn’t have thought the market would rally 37% in 58 days.
By dollar-cost averaging, you’ve helped smooth out the impact of price volatility. Over the course of five months, you were able to buy 173 shares with an average price per share of $295.
An extraordinary example for an extraordinary time
If the price swings in the previous example look significant, it’s because they are. So far, 2020 is shaping up to be one of the volatile years on record for the financial markets, even when comparing 2020 with past recessions and bear markets. Nearly 25% of all trading days resulted in price swings of 3% or more for the S&P 500 and March was the most volatile month in the index’s history with 5% average daily swings.
The fastest bear market in history has (so far) led to an equally stunning recovery. This showcases the benefits dollar-cost averaging can provide, especially in volatile markets. It also highlights some of the limitations.
Hindsight bias is always there
Especially in volatile markets, dollar-cost averaging can help investors avoid big on-paper short-term losses compared to if they had invested all of their money at once on what happened to be the ‘wrong’ day. You won’t benefit from a full investment if you happen to invest at the bottom of the market, but you could also could avoid buying all your shares at the top only to plunge into a bear market.
Since we only know the best time to invest in hindsight, dollar-cost averaging helps reduce the risk of getting an extreme outcome, whether positive or negative.
Dollar-cost averaging makes it easier to stick to the plan
The reality is that many investors don’t like to invest more when the market is down. When everyone is selling and there’s a tremendous amount of uncertainty, it’s difficult behaviorally to go against the trend. In hindsight, after the market has recovered, investors often regret not taking advantage of what they now know to be a great buying opportunity.
Dollar-cost averaging by investing a fixed amount at predetermined intervals can help investors stick to the plan without second-guessing their decisions or getting too emotional as market conditions change. This strategy can help ensure investors aren’t holding cash instead of investing and missing the market recovery.
Dollar-cost averaging vs investing a lump sum
There is no one perfect way to invest cash every time. Dollar-cost averaging can help reduce the impact of short-term price swings, but there’s only so much you can do to plan for a market crash.
One of the downsides to dollar-cost averaging is the opportunity cost of holding onto extra cash. Especially if you plan to invest cash over a longer period, you’ll likely miss out on dividends and income during this period.
The market tends to go up more than it goes down. The pandemic just ended the longest bull market in history. If you had dollar-cost averaged over the last several months of 2019 instead of the beginning of 2020, the $10,000 investment would likely have bought you fewer and fewer shares each month. Which brings up another risk: that the market only goes up during your investment period.
So why discuss the benefits of dollar-cost averaging if research says otherwise? Because too often investors downplay the behavioral aspects of investing until faced with a big decision that carries risk. So when the thought of putting all your money in the market at once seems too stressful—don’t! Dollar-cost averaging can help individuals sleep at night and avoid making fear-driven decisions about whether to invest at all.
Time in the market over timing the market
The stock market is no place to invest for quick returns. While dollar-cost averaging can help reduce the short-term impact of price swings on your performance, consider focusing on the long-term goals you’re investing for instead.
Time in the market is better than timing the market over the long-term, 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 dollar-cost averaging helps investors stick to their plan when they have capital to put to work. Whether you choose to invest a lump sum or over time, try not to Monday-morning quarterback your decision. Hindsight is always 20/20.