Dollar cost averaging is the periodic investment of funds, while market timing refers to investment decisions based on market conditions. These strategies determine how and when investors allocate their surplus cash into stocks, bonds, mutual funds and other financial assets. The choice of an investment strategy is important because it affects a portfolio's annual return on investment.
Dollar Cost Averaging
Dollar cost averaging involves investing the same amount of money at regular intervals, usually monthly. The main advantage is that investors could buy more assets at lower prices than at higher prices. For example, if an investor buys $100 worth of shares each month and the annual trading range for the shares is between $10 and $20, he avoids the risk of buying these shares at peak prices if he were to make one lump-sum investment. The downside to dollar cost averaging is that investors would have no opportunity to buy additional shares at lower prices if the markets are in a prolonged bull market. However, a sharp market correction or a sustained bear market could allow investors to reduce the average cost of holding financial assets through dollar cost averaging.
Market timing involves entering and exiting investment positions based on current or historical market trends. Using a combination of fundamental analysis, which considers the operations and industry environment of companies, and technical indicators, which use price and volume charts to predict future prices, market timers attempt to maximize returns by exiting weakening and entering strengthening positions. For example, if technology stocks are underperforming the market as a group, market timers may switch to outperforming groups, such as mining or consumer stocks. If the stock markets are in turmoil, investors may move into bonds and switch back to equities when markets stabilize. The main advantage of the market timing strategy is that an investor can generate above-average returns if she gets her timing right. For example, investors who sold just before the 2008 financial meltdown and bought at the market lows in early 2009 would have generated substantial returns. However, the disadvantage of this strategy is that success depends on accurately predicting market peaks and troughs, which is impossible to achieve consistently.
Investors could use a combination of the dollar cost averaging and market timing strategies. In a research note hosted on its website, New York-based investment advisers Gerstein Fisher suggest two such combinations. For example, investors could invest more money following a negative month in the markets and less following a positive month, thus benefiting from a lower average dollar investment cost. Conversely, investors could follow prevailing market trends and invest more following a positive month and less following a negative month, thus profiting from market momentum.
Dollar cost averaging is a passive strategy that does not require investors to monitor markets for appropriate buying and selling opportunities. Market timing does require constant attention to market movements. However, these strategies cannot prevent portfolio losses in prolonged bear markets or when the underlying fundamentals of financial assets deteriorate.