Dollar-cost averaging is an investment strategy that involves contributing an equal amount to your portfolio every month, regardless of how the markets are performing. What this means is that you buy more shares when prices are low and fewer when markets are high, in line with the investment mantra of “buying low and selling high.”
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But what are the real benefits of dollar-cost averaging, and does it work just as well when markets are at all-time highs? Here’s a look at all you need to know.
When Markets Are High
It can be tough to keep investing while markets are at all-time highs, as they have been lately. This is particularly true if you are just beginning a long-term investment program. While no one wants to put money in right before the markets drop 10% or 20%, dollar-cost averaging is still a prudent call. No one can know with certainty what markets will do over the short run, and what seems like a high price today will likely be looked at as a “good” price down the road.
If markets do drop immediately after you invest, that’s also not the end of the world. Dollar-cost averaging will start picking up more shares when the market is down, giving you even larger profits when markets eventually recover.
Over time, dollar-cost averaging, as the name implies, will give you an “average” market price, meaning even if you initially buy in at all-time highs, your long-term price will average down.
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When Markets Are Low
Dollar-cost averaging can really pay off when markets are low. Although it can be emotionally difficult to invest when it seems like the market goes down every day, over the long run, these investments made at lower prices will really pay off.
In fact, the longer a bear market lasts, the cheaper the average cost of your portfolio will be.
The True Benefits of Dollar-Cost Averaging
The bottom line is that most investors don’t perform as well as the overall market because emotion is involved. When markets are booming, investors tend to put even more money in, chasing rallies that they think will never end and confirming their false beliefs that they are above-average investors. But when markets turn bearish, they tend to panic and sell their positions, right at the time when they should be buying more.
The big strength of dollar-cost averaging is the way it removes emotion from your decision-making and keeps you consistently invested. This, in turn, can lower your stress about investing and let you sleep at night.
How Does Dollar-Cost Averaging Compare With Lump-Sum Investing?
Historically, lump-sum investing does tend to outperform dollar-cost averaging, according to Northwestern Mutual. However, there are two huge caveats to this.
First, most investors don’t have a giant lump sum to invest. As most Americans are living paycheck to paycheck, their only option for investing is to take money out of their paychecks monthly and sock it away. Secondly, dollar-cost averaging can reduce the lifelong volatility of your portfolio. As you’ll be continually investing whenever markets are low, the market’s regular corrections and bear markets won’t be as painful. Overall, it will help even out the ups and downs of your portfolio.
But yes, if you’re in the position where you’ve got a large lump sum of $100,000 to invest, for example, historically speaking, you’ll be better off putting it into the market all at once. But you’ll need a long-term perspective to make this work out. You’ll just need the emotional resilience to ride out big swings in your portfolio as the market bounces around.
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This article originally appeared on GOBankingRates.com: How Dollar-Cost Averaging Can Help Your Portfolio Now
