If you’re a believer in dollar-cost averaging, there’s really no better time to employ the strategy than during a bear market. After all, the whole idea behind dollar-cost averaging is that you pick up more shares of stock when prices are cheap and fewer when they are expensive. The shares you pick up at a lower cost end up being your shares with the biggest gains in the long run.
Although no one can predict short-term market movements, and the bear market of 2022 may yet have further to run, by dollar-cost averaging now you’ll be lowering the average cost of your existing positions, making it easier to turn a profit going forward. Here’s a look at how dollar-cost averaging works and why it’s particularly effective during a bear market.
How Does Dollar-Cost Averaging Work?
The strategy behind dollar cost averaging is simple. All you have to do is regularly invest a similar amount of money into your portfolio, be it daily, weekly, monthly or even quarterly. Over time, you’ll generate an average cost for your shares, buying fewer when they are priced high and more when they are priced low. Dollar cost averaging used to be harder to do with individual stocks, as you would have to wait until you could invest enough to buy whole shares of stock. But many brokers now allow customers to buy fractional shares of stock, making dollar cost averaging much easier.
Example of Dollar-Cost Averaging
Imagine you are keen on Apple stock and make an initial purchase of $1,000 when the stock is $100 per share. This will give you 10 shares of Apple stock. If you continue to make $1,000 monthly purchases, your share count will increase by varying amounts, depending on the stock price at the time. Here’s an example:
- $1,000 at $95/share = 10.53 shares
- $1,000 at $84/share = 11.90 shares
- $1,000 at $92/share = 10.87 shares
- $1,000 at $99/share = 10.10 shares
- $1,000 at $108/share = 9.26 shares
- $1,000 at $115/share = 8.70 shares
After these seven purchases, you will have invested $7,000 and you will own 71.36 shares of Apple. This puts your average cost at $98.09/share. As you can see from the statistics above, you will have bought more shares when the price of Apple was lower, and fewer shares as it rose higher.
Why Is Dollar-Cost Averaging Effective During a Bear Market?
Dollar-cost averaging during a bear market is particularly effective over the long run because you are scooping up additional shares at low prices. Although there’s no guarantee that the market as a whole will go on to make new highs, it has never failed to do so — historically speaking.
By continuing to invest when the market is low, you are guaranteeing a lower average cost for your shares. Additionally, this forced investment removes emotion from the equation, which can be crippling during a bear market. Many investors simply sit by the sidelines in fear and watch the market go down but then fail to invest again until it is back at all-time highs. If you’re consistently investing, however, you are always buying when the market is low, thereby participating in the eventual market recovery.
How Can Dollar-Cost Averaging Hurt You?
Although the major market averages have always gone on to make new highs after a bear market, the same is not true of individual stocks. It’s entirely possible that if you make poor stock selections that your dollar-cost averaging strategy will only drive you into a deeper hole, as your stocks either fail to recover or simply continue to fall.
Another risk of dollar-cost averaging is that you may be diminishing your long-term returns. If you only buy when the market goes down, for example, you’re more likely to generate profits when it recovers. But if you are committed to a program that requires consistent investing regardless of the market condition, you will by definition be buying shares of stock when they are priced high.
In other words, with dollar-cost averaging, as the name implies, you are averaging out your long-term returns. If you’re ending up with an average cost of your shares, it means you aren’t maximizing your profits by putting in additional money only when those shares are inexpensive.
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