What Is Dollar-Cost Averaging?
There’s an adage in investing: buy low and sell high. It makes perfect sense. The problem is that pulling it off is basically impossible. That’s because markets tend to be volatile from day to day. What if you invest your money only to see markets drop dramatically over the next week? Contrarily, what if that fear prevents you from investing and markets rise dramatically while you have money in a checking account?
While some investors go “all in” on a stock or fund and invest a lump sum of money in one fell swoop, others use a strategy known as dollar-cost averaging. What is dollar-cost averaging? It simply means investing smaller increments of cash in a stock or fund periodically to build a position over time rather than all at once. There are a couple primary ways to use dollar-cost averaging to your advantage.
DOLLAR-COST AVERAGING CAN SMOOTHE THE PSYCHOLOGICAL IMPACT OF VOLATILITY
Because markets rise and markets fall unpredictably, it can be stressful to invest, especially if you’re dealing with a large sum of money. It’s hard to see the value of a large investment decline in a short time, particularly if there are emotional ties to that money, such as an inheritance. Rather than investing all at once, dollar-cost averaging allows you to take several shots over time and smooth the psychological impact of market volatility.
Let’s look at an example of dollar cost averaging. For simplicity’s sake, let’s assume that you have money to invest and are planning to buy a single mutual fund.
Let’s say you have $10,000. One day you spot a fund that’s $10 a share and decide to put all $10,000 into it and purchase 1,000 shares. Next month, the market gets volatile, and your investment declines 50 percent to $5. Now you have 1,000 shares worth $5,000, but the average price you paid per share (your cost basis) is still $10. Over the next three months, that stock rises to $7, $12 and then finally back to $10. It’s been a long trip, but you end up back where you started: 1,000 shares at a cost-basis of $10.
Now, let’s see what would happen in that same scenario using dollar-cost averaging. You instead initially invest $2,000 of that $10,000 and purchase 200 shares at $10. Over the next four months, you invest $2,000 when that stock is $5, $7, $12 and $10. In this scenario, you end up with 1,251.7 shares at a cost-basis of $7.99. When the stock was $5 and $7, you bought far more shares even with the same contribution of $2,000. That, in turn, lowered your overall cost basis. As a result, when the fund returned to $10, your position was up roughly 20 percent rather than even.
Of course, the inverse would be true if the stock price only went up from $10. Ultimately, you’d end up with an average price per share higher than if you invested a lump sum. And, according to research by Northwestern Mutual, investing a lump sum all at once tends to outperform dollar-cost averaging over time (it has more time to capture upside in markets). However, there is more to investing than performance. You also want to sleep well at night, and dollar-cost averaging may help you get acclimated to markets and worry less about volatility.
DOLLAR-COST AVERAGING IS JUST A GOOD INVESTING HABIT
Dollar-cost averaging can be helpful when you’re worried about volatility in the market. But it’s also just a good habit for consistently investing small amounts of money — perhaps dedicating a portion of every paycheck to go to an investment account. If you’re regularly contributing to your 401(k), you’re probably already dollar-cost averaging.
Saving this way means market declines are an opportunity, because your monthly contribution will get you more shares of a favored stock or fund. Committing a specified portion of your income to investments makes it easier to fit saving for the future into your budget as it becomes a regular line item like paying the bills. And, once you commit to an amount you want to invest, you can automate the process. Lastly, this investing strategy helps investors avoid another common pitfall: timing the market. Waiting for the S&P 500 to drop or recover to a specific level before jumping in could leave you on the sidelines for months or years. Remember, time in the market beats timing the market. Dollar-cost averaging makes it easier to always have skin in the game, whether we’re in a recession or at record highs. And, ultimately, that commitment is key to building wealth over the long term.
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