One of an investor’s worst fears is buying a security, such as a stock or bond, and seeing the price drop immediately after the purchase. Talk about regret. Sure, the possibility exists that the security may move higher after your purchase. In that case, you’ve made a profit and feel very happy. However, add volatile financial markets, with the Dow Jones rising 300 points one day and dropping 400 points the next, the probability of experiencing regret increases significantly as well. Market volatility is unlikely to abate in the near term, so how does one navigate in this market environment? For example, you want to buy $10,000 of Apple stock (AAPL) for your portfolio, but the stock price is near all-time highs. Should you buy now or wait in hopes the stock price will fall lower? Isn’t that “market timing”, which you know is a losing game?
This is where the concept of dollar-cost averaging comes in. Dollar-cost averaging removes emotions from the equation. It is placing a trade across different market periods to arrive at an “average cost” for the position. In the Apple example, you can spread the $10,000 trade across two or three time periods. Buy $5,000 of AAPL now and the remaining $5,000 in 30 days. After making the second purchase, you’ll have half of the Apple position at one price and a half at a second price. The total cost for this position is the average of the two purchase prices, and you’ve removed the risk of buying too high within this 30 day period. If the AAPL stock price is HIGHER in 30 days, well, your first tranche was at a lower price point. If the AAPL stock price is LOWER in 30 days, you can take advantage of the lower price by buying your second tranche. The same concept applies to selling securities as well, where you run the risk of selling too low.
Dollar-cost averaging is a systematic method of buying and selling securities and allows you to calmly navigate through volatile market environments. You may have just reduced your risk of “regret.”