Dollar-Cost Averaging: How and When To Use This Investment Strategy
“Buy low, sell high” is common advice among investors — but timing the market can be a full-time job. No one knows what the market is going to do from one hour or one day to the next, and investors can lose a lot of time, energy and money trying to guess. That’s where dollar-cost averaging comes in.
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What Is Dollar-Cost Averaging?
Put simply, dollar-cost averaging is a measured approach to investing that values steadiness. Rather than spending your time watching and trying to adjust for every market fluctuation, you simply decide that you’re going to dedicate a consistent amount of money toward your investments on a regular basis. When you do this, you sometimes buy low and other times, at a high. The idea is that your average price point equalizes over time.
The most common example of dollar-cost averaging is a 401(k) plan. When you open a 401(k), you allocate a percentage of your income to invest in the plan. Each of your paychecks reflects the same deduction — for example, 5%. Those funds buy shares of the securities you’ve selected for your 401(k), which are usually index funds, mutual funds, ETFs or some combination. You can also invest in each of these options outside of a 401(k) using investment vehicles like an individual retirement account or a brokerage account.
How Dollar-Cost Averaging Works: Crunching the Numbers
As an investor, you want your money to go as far as possible. For example, let’s say you have $600 to invest. You’ve done your research and decided on an investment, such as a balanced mutual fund with a strong history of solid returns and a low expense ratio.
The amount of money you’re going to put into that fund — $600 — will not change, but the price per share of your investment of choice will as the market moves up and down. These fluctuations mean that your $600 will purchase fewer shares if you buy when your chosen fund is at a higher price, or it will buy more shares if you purchase when the fund’s price is lower.
Here’s a look at how your purchases might break down over the course of a year:
Since the share price varied throughout the year, you were able to buy more shares some months and fewer shares in others.
If you had spent your entire $600 when the share price was at its lowest — $7 — you would have purchased 85.71 shares.
If you had spent your entire $600 when the share price was at its highest — $13 — you would have purchased 46.15 shares.
By dollar-cost averaging, or making a consistent investment of $50 each month, you would have ended up with 64.61 shares. That’s near the middle point between buying low and buying high. You can feel confident that you made your $600 stretch as far as possible without having to be glued to daily market news, vigilantly watching for ups and downs.
Who Should Consider Dollar-Cost Averaging?
Anyone can use dollar-cost averaging to try and grow their wealth, but it can be a particularly good fit for the following individuals.
Investors Tempted To Try For a Quick Buck
If the desire to hustle runs through your veins, then you are vulnerable to hasty decision-making as the market goes up and down. This approach can get you interested in edgy companies with the potential to be the market’s next lightning bolt, rather than more stable investments. You can also lose a lot of money by buying and selling during market swings, even if you intend to use them to your advantage.
Investors Prone to Fear
On the opposite side of the coin, fearful investors are equally vulnerable. You may find yourself sitting on your cash, unwilling to wade into the market. If you do invest, you could be prone to panic during market lows — and if you sell before you’ve owned an investment asset for less than a year, you may face higher taxes on any capital gains than you would if you’d sat on that purchase for a while.
The amount of time your investments spend in the market matters, so it’s important to keep fear in check.
Would-Be Investors With Impostor Syndrome
Generally, the most vulnerable investors of all are the ones who never wade in. Investing is scary for many people, and they don’t typically learn about it at home or school. If this is you, there’s no shame in that, but dollar-cost averaging could be a comfortable way for you to begin investing.
Financially speaking, there’s no better friend than compound interest or the momentum that your investments gain over time. Although investing always carries some risk, there are ways to invest that help minimize that risk and provide the strongest opportunity for your wealth to grow gradually.
What Are the Pros and Cons?
Every investment strategy carries some risk. Before you decide how to spend your investment dollars, know the pros and cons.
Advantages of Dollar-Cost Averaging
When you decide to consistently allocate a fixed amount of money toward a security or an array of securities, you are eliminating the potential for your emotions to run your investment strategy. You’ve predetermined that the same amount of money is going into the market at regular intervals.
When the market is at a low, your fixed dollar amount will buy more. When the market is riding a high, your fixed dollar amount will buy less. These purchases should balance each other out over time in a successful dollar-cost averaging strategy, placing you ahead of where you’d be if you had made sporadic or less regular investments.
Risks of Dollar-Cost Averaging
On the surface, this steadfast approach seems reasonable, but there are a couple of drawbacks.
1. Your Chosen Investments Need To Grow
Putting a fixed amount in the market at regular intervals works well if the investments you select perform well over time. When you’re able to buy during highs and lows, your overall price point tends to land in the middle.
However, you don’t want to consistently allocate money toward an investment that isn’t doing well. If you’re buying at a low point month after month and not seeing a return, then you may be sinking money into a security that is not likely to make gains. That’s a position that no investor wants to be in, so think twice about using a consistent approach in this case.
2. You’ll Need To Watch Your Fees and Taxes
As an investor who uses dollar-cost averaging, you must understand the value of a consistent approach and that you’re investing for the long term. If you’re using a buy-and-hold strategy, your trading fees should be relatively low. If you start to buy and sell more often, be aware that those activities may lead to more trading fees and capital gains taxes.
3. Money That Sits in Savings While Your Dollar-Cost Average Stagnates
If you hold a sum of money in savings with the intent to dollar-cost average it into the market over time, you could lose money in the long run. If you’re dollar-cost averaging from a paycheck, as you do with a 401(k) plan, you’re investing in real time and are not at risk of this. However, if you’re holding money in a low-interest savings account specifically to invest it using dollar-cost averaging, you might be better off investing it sooner than later.
Tips for Getting Started With Dollar-Cost Averaging
If you’re sold on this strategy but not sure how to begin, here’s some guidance.
Pick an Investment Vehicle
This could be a 401(k), an IRA, or a brokerage account that you direct money to regularly.
Choose a Frequency
In some investment vehicles, such as a 401(k), the frequency of your contributions is preset to every pay cycle. If you’re going to use dollar-cost averaging to direct funds to an IRA or a brokerage account, then you’re in charge of how frequent your contribution is. You may choose daily, weekly or monthly.
Set Your Contribution (and Forget It)
Figure out how much you can afford to dedicate to your chosen investment. Does 5% of your net income work? How about 10%? Make sure that the amount you choose is going to work, given the frequency of your contribution. This is the investment strategy that people often refer to as “set it and forget it.”
Managing a Dollar-Cost Averaging Strategy Over Time
The more experienced you become as an investor, the more tempted you’ll be to diversify your investing strategy. You might find that dollar-cost averaging works for a portion of your portfolio, but that giving yourself a little bit of leeway for more time-sensitive investments makes more sense. This largely depends on your level of knowledge and experience.
Here are a few takeaways to keep in mind when considering this strategy:
No matter how you decide to invest, the consistency that dollar-cost averaging brings to your financial life is an asset in and of itself. When you invest steadily over time, you buy at both ups and downs. This leaves you in the best position possible for growth without having to fixate on market fluctuations. That’s bound to be a reassurance for any investor.
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Last updated: May 26, 2021
This article originally appeared on GOBankingRates.com: Dollar-Cost Averaging: How and When To Use This Investment Strategy
