Use Dollar-Cost Averaging to Build Wealth Over Time
In February, it bought 62.5 shares, in March it bought 83.3 shares, in April it was 58.2 shares, and in May it was 43.48 shares. Dollar-cost averaging only makes sense if it aligns with your investing objectives. If you are investing in a stock or other asset because you like its long-term prospects, and have decided on an amount to invest, then making a lump-sum investment when you make that decision may be the right tactic. Those who remain invested during bear markets, for instance, historically have seen better returns than those who withdraw their money and then try to time a market return, according to Charles Schwab research. Dollar cost averaging gets smaller amounts of your money into the market regularly. This way, you don’t have to wait until you have a larger amount saved up to benefit from market growth.
It can also serve as a risk management trading strategy if you end up buying more when the price is relatively lower—and buying less when the price is relatively higher. Dollar-cost averaging is a good idea for those who do not have the confidence or expertise to time their investments. It is also a good tool for those who want to reduce volatility, as they will buy more units at lower prices and less when prices are higher.
Dollar-cost averaging is a strategy that can make it easier to deal with uncertain markets by making purchases automatic. Imagine an employee who earns $3,000 each month and contributes 10 percent of that to their 401(k) plan, choosing to invest in an S&P 500 index fund. Because the price of the fund moves around, the number of shares purchased isn’t always the same, but each month $300 is invested. It only takes a little bit of time upfront to set up a reinvestment plan.
Investing set amounts at regular intervals
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. For example, it may be suitable for a new investor who is only starting to learn the intricacies of the market. With the reduced risk, you can be confident that your money is safe and that any losses are minimized. Say that, instead of using dollar-cost averaging, Joe spent his $500 at one time in pay period 4.
However, you are unsure when and at what price you would like to buy the stock. Using a dollar-cost averaging approach, you might decide to invest $1,000 a month for 5 consecutive months. An alternative approach to dollar-cost averaging is known as lump-sum investing. It is a high-risk, high-reward strategy that entails investing a large sum of money at once to capitalize on market conditions and any discounts or gains due to the size of the investment. This approach is suitable for experienced investors with significant market knowledge and access to a large sum of money. When dollar-cost averaging, you invest the same amount at regular intervals and by doing so, hopefully lower your average purchase price.
- It’s one of the most powerful and easy investment strategies and it’s great for individual investors.
- In that scenario, it’s best to get it invested relatively quickly, but you could still spread out purchases over a few months to take advantage of potential volatility.
- Once you commit to dollar-cost averaging, you are set on making regular investments regardless of what happens in the markets, which could mean missing out on important investment opportunities.
A Long-Term Strategy
If you’re planning to use it for long-term investing and wonder what interval for buying makes sense, consider applying some of every paycheck to the regular purchases. The key advantage of dollar-cost averaging is that it reduces the negative effects of investor psychology and market timing on a portfolio. Instead, dollar-cost averaging forces investors to focus on contributing a set amount of money each period while ignoring the price of the target security. By adding money regularly, you’re going to buy at times when the market is lower, therefore lowering your average purchase price and actually acquiring more what is being done when shares are bought and sold shares.
It reduces the risk of buying an asset at its peak price and losing significant amounts if the value decreases shortly after purchase. Dollar-cost averaging reduces market risk because you invest at various prices rather than at one specific price. It helps protect your investments against sharp market movements while allowing you to earn long-term profits over time. Dollar-cost averaging also protects investors from buying into overvalued markets and enables them to buy more shares when the prices are lower and fewer when they are higher. In effect, it levels out risk by averaging the effects of market volatility.
What is the approximate value of your cash savings and other investments?
The main disadvantage of dollar-cost averaging is that in a market that generally rises over time, you’ll likely be better off being fully invested as soon as possible. But because most people are saving and investing as they earn money, dollar-cost averaging is the next best option. Instead of focusing on the ins and outs of “timing the market,” or making predictions on price movements, dollar-cost averaging is about consistently putting money into the market despite any gains or losses. The stock market is well-known for its ups and downs and trying to “time the market” can be difficult, especially if you’re just getting started with investing. For example, if you made a $25 installment payment in a mutual fund that charges a 20 basis-point expense ratio, you would pay a fee of $0.05, which amounts to 0.2%. For a $250 lump-sum investment in the same fund, you would pay $0.50, or 0.2%.
Even experienced investors who try to time the market to buy at the most opportune moments can come up short. Less-experienced investors usually opt for a fund, and some of the most diversified funds are based on the Standard & Poor’s 500 index. This index includes hundreds of companies across all major industries, and it’s the standard for a diversified portfolio of companies. If you want to buy an S&P index fund, here are some of the top choices.
Dollar-cost averaging: How to use the strategy to build wealth over time
In that scenario, it’s best to get it invested relatively quickly, but you could still spread out purchases over a few months to take advantage of potential volatility. Dollar-cost averaging works because it’s about consistently funding your investments and putting money into the market, rather than holding back and attempting to time the market. “It’s probably the most effective strategy for all investors at all levels. It’s one of the best ways to set it and forget it but you do want to pay attention to what you’re investing in,” says LaFleur.
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It is also suitable for investors who regularly invest through 401(k) plans or IRA accounts. On the other hand, lump sum investing allows investors to capitalize on bull markets and reap the highest returns possible during those periods, which is not necessarily true with dollar-cost averaging. Since you afford fewer shares when prices are high and more when prices are low, you will likely pay a lower cost per share over time than if you invested all your money at once. The amount of shares you gain fluctuates depending on the share price at the time of purchase. For instance, investors can use it to make regular purchases of mutual or index funds, whether in another tax-advantaged account such as a traditional IRA or a taxable brokerage account. Since stocks can fluctuate a lot over short periods, try to allow the investment some time to grow and get over any short-term declines in price.
In addition, mutual funds and even individual stocks don’t, as a general rule, change in value drastically from month to month. You have to keep your investment going through bad and good times to see the real value of dollar-cost averaging. Over time, your assets will reflect both the premium prices of a bull market and the discounts of a bear market. Dollar cost averaging is a strategy to manage price risk when you’re buying stocks, exchange-traded funds (ETFs) or mutual funds. Instead of purchasing shares at a single price point, with dollar cost averaging you buy in smaller amounts at regular intervals, regardless of price. Whether dollar-cost averaging is a better approach than lump sum investing depends on your individual situation.
Since each periodic contribution has already been set aside for investment purposes, investors are less likely to be concerned with short-term market movements. Bear in mind that the repeated investing called for by dollar-cost averaging may result in higher transaction costs compared to investing a lump sum of money once. It isn’t necessarily appropriate for those investing time periods when prices are trending steadily in one direction or the other. Be sure to consider your outlook for an investment plus the broader market when making the decision to use dollar-cost averaging.
If you have a 401(k) retirement account, you’re already practicing dollar-cost averaging, by adding to your investments with each paycheck. If you want to take part in dollar-cost averaging, the first step is to select the security you want to invest in. This could be shares of stock, for example, or an exchange-traded fund (ETF), a security that can quickly offer broader exposure to many different assets, for example a basket of blue-chip stocks in the stock market. If you have a large sum of cash to invest or you’re investing for a specific goal over the short term, lump sum investing may be a good fit.