Every investor wants to buy when share prices are low and sell when share prices are high.
If only it was so easy.
In reality, guessing the market highs and market lows is a fool’s game.
You are unlikely to get it right over and over again.
But if that’s the case, how should you get started investing without taking too much risk?
Let’s find out!
What is Dollar Cost Averaging?
Imagine winning a lottery and receiving a million dollars.
Would you invest the entire million dollars in one go?
Or will you ration it out and invest regularly with smaller sums?
I’ll bet it is the latter.
Dollar cost averaging (DCA) is an investment strategy where you invest your money in regular, fixed dollar contributions based on a fixed schedule.
This approach stands in contrast to lump-sum investing where an investor invests the bulk of his or her amounts of money at one go.
The benefits of DCA
But why should you consider DCA when you invest?
Let’s take a look at its benefits.
1. Simple
DCA is one of the easiest ways for anyone to start investing.
All you need is to set aside your paycheck every month and invest regularly into the stock market, regardless of the overall price level.
By doing so, you can let the market take its course while you watch your investment grow over time.
2. Reduces investment risk
Employing DCA significantly reduces the impact of volatile market prices.
Because you are investing fixed amounts, when prices are high, you end up purchasing less shares.
When prices are low, you will buy more shares.
You stand to purchase the stock at a bargain without any timing risk involved and avoid buying too much when share prices are high.
By doing so, you lessen the risk of over-committing to a stock at higher valuations or when the market is bullish.
3. Eliminate emotional hurdles
You probably know how stressful it is to see a “sea of red” in your portfolio.
If you have invested a lump-sum in a basket of stocks and the market crashes, you are more likely to sell in a panic.
However, by investing small sums each time, you are less likely to be overwhelmed by your emotions and make the wrong decisions.
DCA helps to tame the emotional aspect of investing through a disciplined, mechanical investment approach.
Be aware of the flip side
While DCA may help to reduce investment risk, it does not guarantee good performance of the portfolio if you purchase stocks that turn out to be lemons.
Hence, proper due diligence is important to identify and buy great companies after careful research.
This consistent approach of investing also does not take into consideration potential risks the company may be facing (for instance, a company with too much debt, losing market share from competition etc).
Hence, DCA is neither risk-free nor a substitute for diligent investment research.
Get Smart: Weighing the pros and cons
Each method you choose has its advantages and disadvantages.
As such, you need to consider each approach carefully before deciding on a method that you feel is most suitable for yourself.
Meanwhile, the principles of Smart Investing should remain, whichever approach you choose to take.
You should always aim to buy great companies with great management teams and hold them for the long term.
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Disclaimer: Jia Yi does not own any of the companies mentioned.