As financial advisors, one of the most common questions we receive is, “Is now a good time to invest?” The inquiry often comes from someone who has a large amount of cash on the sidelines. They’re interested in putting the money to work, but nervous about the direction the markets might go.
Of course, there are reasons people remain nervous about investing. The COVID pandemic has brought issues to the table that we had never seen before. In 2022, Russia launched a large-scale attack on Ukraine, inflation hit its highest level in over 40 years, and the stock market saw its worst year since 2008… just to name a few.
As always, our first piece of advice is to avoid trying to time the market. This is a fool’s errand. The market is smart, and it already has most of what you think may be an opportunity baked into its price. But it’s especially hard to time the market with all of the aforementioned issues, which have increased volatility to insane levels.
With that said, we know that the market will make a comeback, but nobody can say for sure when and what that will look like.
We also know that sitting cash on the sidelines, which loses purchasing power due to inflation, can be an even worse path to take. So what can we do to avoid making costly mistakes when “getting into the market?” We recommend considering dollar-cost averaging.
What is Dollar-Cost Averaging?
Dollar-cost averaging makes it easier to invest in uncertain times because the purchases are automatic. This approach buys the same security or same portfolio at regular intervals regardless of the price, therefore hedging against volatility risk and taking emotion out of the equation.
It also helps you invest regularly and allows you to focus more on your overall investment strategy. In the end, this will lower your cost per share and reduce the impact of volatility.
Let’s look at an example. In a time of extreme volatility the stock portfolio of Stock A is on a roller coaster ride. We have $12,000 to invest and instead of trying to time the market and invest the entire $12,000, we decide to adopt a dollar-cost average approach and invest $1,000 on the first of the month for the next year. During this time, Stock A fluctuates between $30/share and $50/share. With our approach, our price per share at the end of the year is roughly $40/share. We could have gotten lucky and invested all of the $12,000 at the $30 share price but it also comes with the risk that we might have bought closer to the $50 price. So, to be clear, this is a hedge. At the end of the period we know we have the best average price per share over that time without taking on the volatility risk. And we didn’t expose ourselves to the possibility of making mistakes due to emotions that are typical during times of volatility.
|Stock A||Contribution||Shares Bought||Shares Owned|
|Average||Total Contribution||Total Shares||Investment Value|
What to Consider When Dollar-Cost Averaging
There are a couple things to consider when looking at implementing dollar-cost averaging as a strategy. First, you should make sure that your timeline is appropriate for this strategy. This will not protect you from downside risk in the event you have a short timeline from when you invest until when you will need to liquidate the portfolio for use, whatever that may be. Dollar-cost averaging is most effective during times of volatility and will still rely on the long term increases in the market.
Second, you should make sure your portfolio is appropriate for your risk tolerance and overall financial plan.
Related: Get Your Personalized Risk Score
We understand that these times are extremely stressful. There are a lot of moving parts – and even more unknowns – but with the right strategy, you can hedge against risk and come out on top. If you have any questions about dollar-cost averaging or about your specific situation, we would be happy to set up a call to discuss.