Investing is about making the right decisions by taking into account the market situation and your individual goals. When a particular market is volatile, investors are naturally worried and this can lead to the making of mistakes. It is true that it is scary to see your portfolio’s value diminishing, but this doesn’t mean that you have to give up investing. You will surely lose more if you do. There are generally two main ways to invest your money when the market is volatile – dollar cost and lump sum investing. Here we will look at the situation and the two options in detail and make a comparison to help you make the right choice.
Understanding Market Volatility
Volatility is defined as the predisposition of the market to make big drops and rises over a short period of time. It is measured with the use of standard deviation, which shows the magnitude of the deviation which you can expect. In stock markets, the volatility is much higher than in the market for government bonds, for example.
What you should know as an investor is that volatility is something normal. It is part of the risk which you assume when you put money in financial instruments and especially in stocks. Another important thing to note is that volatility is associated with the short term. One interesting fact is that the long term trend is for stock markets to rise despite short-term ups and downs. The last point which you have to keep in mind is that very often stock price fluctuations are driven by external factors which have little or nothing to do with the value of the company itself. This means that better times will most certainly come despite rough periods. The conclusion: don’t pull out your investment, but choose the right strategy for a volatile market.
Lump Sum Investing or Going All In
There is nothing complex about this technique. You determine how much money you want to put it and buy stocks directly with it. It is important to keep in mind that this technique is in no way in conflict with the main rule of investing – portfolio diversification. You should choose different types of stocks for your portfolio to lower the overall risk for your investment. The more diverse the stocks are the better.
Dollar Cost Averaging Explained
This concept is a bit more complex and deserves detailed explanation. It is generally used only for volatile markets like the stock one. It is rarely applied with investment in bonds. Dollar cost averaging, or DCA for short, is all about dividing the total amount of money which you have set aside in equal portions and investing them over set periods of time. It is up to you to decide on the frequency of the investing. Usually, new stocks are purchased every month or every three months (on a quarterly basis).
The primary purpose of dollar cost averaging is to reduce the risk associated with the timing of the investment. If you invest all of your money in portfolio of stocks for a set price and then this price goes down over the course of the next few months, you will be losing money. You can reduce this loss by buying smaller amounts of the stocks in the portfolio every month.
Here is an example which illustrates how dollar cost averaging can help you practically shield your investment from market volatility. It will be based on a single stock for clarity. Let’s say that you plan to invest in the stock monthly over a period of six months and the prices from month 1 to month 6 are $50, $45, $40, $45, $55, $50. In this case, the average price per share will be $47.5. If you make a lump-sum investment, you will pay a price of $50 for each share.
Comparing the Two Options
When it comes to risk reduction dollar cost averaging is the better option. However, we also have to look at the return side to see the whole picture. Seasoned investors will argue that holding your money instead of investing it right away will bring you practically no return (you can probably get some interest on it, but it will most certainly be very small). Additionally, with the DCA strategy, you may actually miss out on great opportunities for profit if the market or the particular stocks which you invest in move up.
There is yet another way in which you can waste a chance for earning higher returns eventually when you follow a strict dollar cost averaging plan. If the market starts going down and you stop buying to reduce risk, this may actually lead to loss eventually in case stock prices rise. The point is that you should not let short-term volatility affect your investment decisions even if you decide to go for DCA. It is best to determine the level of risk which you are comfortable with and avoid making decisions impulsively.
The big question is whether lump sum investing will bring you greater returns than dollar cost averaging. Historical data analysts say: yes. A recent historical analysis of the US stock market covering the period from 1926 to 2013 has shown that the average one-year returns from lump sum investing are 12.2% while the average for DCA is 8.1%. This is a clear example that by offsetting risk, you get lower returns.
Making a Decision
This is a tough one undoubtedly. As noted earlier, it is best to decide based on how much risk you are willing to assume for the sake of getting higher return. In a volatile market, in particular, dollar cost averaging seems to make more sense. However, you have to ensure that you will not make the mistakes associated with this method which were outlined above. There are two other major factors which you have to take into account too.
Firstly, dollar cost averaging allows you to reduce risk, but this isn’t the only way tool which you have for this. Portfolio diversification is fundamental and will definitely help too. This can involve investing not only in different types of stocks, but in different kinds of financial instruments in general. You can readily consider a fun too. You can also rely on specialized professional advice for the management of your portfolio when the market is particularly turbulent.
The second factor which you need to take into consideration is that dollar cost averaging is not a long-term strategy. It is perfectly possible to use it over the course of as many as two years provided that the amount which you plan to invest is large. However, in the longer term inflation will take its toll and you will lose value. Generally, inflation is always a major factor when it comes to making investment decisions.
Now that you know the pros and cons of both dollar cost averaging and lump sum investing and have all the guidance needed to make a decision, you can go ahead and do it. No matter which option you pick, you should develop a well-rounded investment strategy which matches your goals and risk attitude. Run detailed analysis to ensure that you will choose the right stocks and other financial instruments for your portfolio.