We’ve all done it. You put in a sizeable amount of money into the stock market and the following week your investment is down 5% or 10% on market volatility.
That sinking feeling is completely natural human emotion – it’s called “loss aversion” as my colleague Say Boon Lim has previously written about.
However, being “scared” of potential losses should never hold us back from investing. That’s because volatility (stocks go up as well as down) is a normal part of healthy and functioning stock market.
So, how can we effectively manage our human emotions? Or, even better, take emotions out of the equation when we undertake the process of investing?
One way to suppress those human impulses – of selling at a loss or perhaps trying to chase high-flying stocks – is to consistently invest smaller amounts of money on a regular basis.
This is better known as “dollar cost averaging” (or DCA in financial speak) and it’s a useful way of ensuring your emotions are in check when investing.
Slow but steady investing
Putting a large sum of money into the stock market in one go is called “lump sum” investing. DCA tends to be a more risk-averse and conservative way of putting your money to work as you spread out the money over time.
So, instead of buying $10,000 worth of shares in one lump sum, you buy $1,000 worth of shares every month for 10 months.
This regular investment allows you to sleep easy at night knowing that you’re investing no matter what the market does. This smooths out volatility in pricing.
One great way to ensure you invest every month, if you don’t have access to a regular savings plan, is to immediately invest a set amount into the market on the day you get paid your salary.
Aware of the pitfalls
As with any investment approach, it’s also important to understand the advantages and disadvantages of doing DCA.
Clearly, you have an opportunity cost to spreading out your investments. That cost is effectively the nine months in the stock market that your initial $10,000 could have been working for you.
The longer your money has to work in the market, the better your returns are likely to be. It’s been widely-documented through various studies that in markets that are stable or climbing, lump sum investing outperforms DCA over the long term.
However, when stock markets are falling hard and fast, DCA will outperform a lump sum investment. That’s because you’ll continue to buy and invest when the prices go lower and lower.
That means your average price will be lower than a lump sum amount before or at the beginning of a market crash.
Mix and match
I think DCA is a great way for all investors to make money work for them. Not all of us will have a large pot of money to put to work immediately.
Additionally, using part of your monthly salary to invest rather than saving it up to invest all in one go means you will constantly be drip-feeding money into the stock market.
At the end of the day, there is no “right” or “wrong” way of doing it but rather what approach fits your investing profile.
For those of us who are more prone to letting our emotions control our investment decisions, DCA is the way to go as our impulses are removed from the process.
Personally, I use both lump sum investing and DCA to ensure that I capture the best of both worlds over the long term. For investors starting out, there’s nothing to stop you from doing DCA, lump sum or even both.