Islamic Finance Blog & Articles
What is dollar-cost averaging & how does it work?
Dollar-cost averaging is an investing technique in which the entire amount to be invested is divided into periodic buys of a target asset to decrease the effect of volatility on the total purchase. Acquisitions are made consistently and regardless of the asset's value.
Indeed, this method avoids most of the laborious effort of attempting to time the market to purchase stocks at the best price. The constant dollar plan is another term for cost-averaging on a dollar-by-dollar basis.
Dollar-cost-averaging is a technique for decreasing price risk when acquiring investments such as unit trust or stocks. Instead of investing in a single item at a single price, dollar cost averaging allows you to split the amount of money you want to spend and buy minor amounts of the asset over a period at periodic intervals. This reduces the risk of overpaying for an investment before market values fall.
Is Dollar-Cost-Averaging Effective?
Outside of hypothetical circumstances, dollar-cost-averaging does not always operate as intended. According to Financial Planning Association & Vanguard data, dollar-cost averaging may beat lump sum investments in the long term. Consequently, if you have a large quantity of money, you should invest it as soon as possible.
You may not have a large sum of money saved aside & procrastinating may lead to you missing out on potential profits. Investing a large quantity of money all at once can be stressful; therefore, it may be better psychologically to invest smaller amounts over time.
Furthermore, remember that, in most situations, lump-sum investment surpasses dollar-cost averaging. Dollar-cost-averaging beat lump sum investment about a third of the time. Because it's hard to foresee future market declines, dollar cost averaging provides consistent returns while lowering the danger of falling into the 33.33 percent of lump-sum investment failures.
When should you use dollar-cost averaging?
When dealing with a volatile, active market, dollar-cost averaging works well (AKA most of the time). It operates because of a combination of mathematical and psychological factors. In the preceding example, the statistics speak for themselves. 2+2 has no wriggle space since arithmetic is math & numbers are numbers. However, our brains do not always function in this manner. Because of a phenomenon known as cognitive bias, the psychology of spending & investing is complicated.
The status quo prejudice is a systematic cognitive bias that affects investment. When people "prefer things to remain the same by doing nothing or sticking to a previous decision," they exhibit status quo bias. In banking, for example, a person may remain with the same banking institution because "it's the one they've always used" or "that's the only one they knew about."If you've been dealing with the same investment brokerage platform for years despite the platform's high fees, it's time to make a change. Spend a few hours researching your possibilities and coming up with a superior one.
The emotional labor of investing is removed with dollar-cost averaging. You don't have to consider if this particular move is the best one to make, depending on the market and its timing; all you have to do is invest. It also adds gasoline to the long-term investing fire. When you commit to investing at regular periods to accumulate money over time, it may influence other aspects of your life.
Warren Buffett, one of the most well-known and successful investors, believes in value investing. Keeping your calm is one of the tenets of value investing. Never, ever sell in a panic. The market fluctuates; that's all it does. You're going against the principles of long-term value investment by allowing your emotions to run high & selling when prices drop. It's not a good idea to purchase high & sell low.
This is no longer an option, thanks to dollar-cost averaging.
When is dollar-cost averaging ineffective?
Dollar-cost averaging is the process of splitting your capital into smaller amounts and investing them slowly and equally over time. You potentially eliminate the risk of losing all of your investment if the market has an abysmal day. But what if you apply this technique in a year when the market is doing well, especially if there aren't any significant drops? You may be overlooking some important benefits. Over time, losing out on substantial market gains may accumulate.
Time in the market, on the other hand, always surpasses timing the market. There's no way of knowing if a particular year will be exceptionally wonderful or awful. Almost certainly, it will probably end up being a relatively routine year. Historically, and on average, the stock market has provided investors with a 10% annual return on investment.
How do I begin implementing a dollar-cost-averaging strategy?
Select an investment brokerage platform.
There are many brokerage platform to choose from, for instance like TD Ameritrade, IG, Tiger broker, MooMoo and many more. Some of these broker charge a commission fee as low as $8 per trade and others provide an extensive analysis tools so select your brokerage platform wisely according to your needs and preference.
Set a budget for your investment.
Calculate the monthly sum of money you can set aside.
It's essential to indicate the amount you can commit that is appropriate for your lifestyle and therefore doable on a monthly basis.
The 50/30/20 rules is a popular method of budgeting. Using this technique, you may set aside 20 percent of your income for savings and investment. Invest in the stock market & unit trust that contribute toward this goal. Before you start investing, you should have emergency savings fund set aside or in the works.
Choose your assets carefully.
Assets are divided into 5 classes mainly Stocks or equities; Bonds or other fixed-income investments; Cash or cash equivalents, such as money market funds; Real estate or other tangible assets; and Forex, futures and other derivatives. There are portfolios dedicated to the environment, technology, SaaS, or even blue-chip companies. Take your time & figure out what will work best for you now and in the future. These are long-term investments. Engage a financial advisor to learn more on this financial assets and how can it fit your financial plan.
Invest that money in the assets you've chosen at periodic intervals, monthly or quarterly.
Investing in accordance with your spending plan is not only doable, but it may also be the most effective approach to accumulate money. You may smooth out the stock price ups and down over time by using a dollar-cost averaging method. The benefit of dollar-cost averaging is that some of your stocks will be acquired at a low point, and others will be purchased at a high point. Most importantly is that you stay invested and invest consistently in assets that fit your principles and budget.