Investing Using Dollar-Cost Averaging
Simply explained, dollar-cost averaging means you invest a specific amount of money into the same asset (such as a stock or exchange-traded fund) at predetermined intervals (such as monthly or quarterly), rather than investing with one lump-sum purchase. If you are regularly contributing to a 401(k), you may already be employing a dollar-cost-averaging strategy and enjoying its benefits and not even realize it.
How Dollar-Cost Averaging Works
The stock market goes up and down. If you have a specific amount of money to invest, that amount will buy fewer shares of a stock when the market is up and prices per share are high. Conversely, your money will buy more shares when prices fall. But timing the market to buy low is easier said than done. The unpredictability of the market is what makes a lot of investors nervous.
Dollar-cost averaging helps take some of the risk and anxiety out of investing because it lowers the average cost when markets fall and results in your acquiring more shares for the same money.
Here’s how it works.
Let’s say you have $400 and want to buy shares of Company XYZ at the current price of $10 per share. Spending the full $400 at once, you’ll get 40 shares. If, after four months, the share price is down to $9.50, your investment will be worth $380 (a $20 loss).
Advantages of Dollar-Cost Averaging
After four months of dollar-cost averaging, that same $400 lets you own 43.5 shares instead of 40, with a value of $413.25. Instead of a loss, you have a small positive return since you were able to take advantage of an average price per share that was lower than the initial cost. This is a simplified example, but it demonstrates the value of this approach.
Admittedly, in a quickly rising market, this strategy can also lead to a lower return than you’d get with a lump-sum purchase (particularly in the near term). But it can lower the risk of pouring your money into an investment when prices may be inflated, and it can mitigate total losses due to market volatility.
Dollar-cost averaging offers a more disciplined investment strategy, versus one fueled by panic or overconfidence, and its incremental approach to investing makes it a good fit for those who can’t or don’t want to invest a large lump sum.
Along with diversification and portfolio rebalancing, dollar-cost averaging can be an important way to manage risk when building wealth. Most importantly, it takes the focus off short-term profits and instead focuses on long-term growth – the key to any smart investment strategy.