The thought of investing can be daunting. If you’re just beginning, it can be difficult to know where to start. Dollar cost averaging can help you simplify and automate your investment plan, so you can feel more confident venturing out into the world of investments.
Dollar-cost averaging is an investment strategy where the same amount of money is invested at the same time interval.
Judy has a goal to buy $10,000 worth of a particular stock, but afraid of the volatility in the stock market. She decides not to invest $10,000 all at once. Instead, Judy purchases $2,000 worth of stock per month for the next five months.
This month Judy’s $2,000 will buy 100 shares, because the stock is priced at $20. The next month, the stock went up to $22 per share, and she’s only getting about 91 shares instead of 100. Three months later, the stock is $23 per share, so her money buys 87 shares.
The basic premise of dollar-cost averaging is Judy buys more shares when the stock price goes down and less shares when the price goes up.
The strategy takes the guesswork out of investing. Rather than trying to pick the best time to buy a stock, fund, or any financial asset, you simply automate; buying more shares when prices are low and less when prices are high.
Why Dollar-Cost Averaging Works
Smooth Short-Term Volatility
There are times when the stock market goes up and down in gentle fluctuations, there are other times when it can be quite volatile.
Before the COVID market sell-off of 2020, the Dow topped out at around 29,500. A month later, the stock market had lost more than 30% of its value, and sat around 18,500. It was a stunning market crash, and one which financial experts and individual investors watched with horror.
How would this have played out for a dollar cost average investor? She would have gotten more shares because stock prices were lower (if prices fell far enough, she might have invested her entire cash hoard!). Also, because part of her funds were still in cash, she didn’t realize losses on the non-invested funds.
By employing the dollar cost averaging strategy, you can discipline yourself to put a certain amount of money towards investments on a regular basis.
A person on an automatic savings plan takes the guesswork out of investing, market timing, and investment decisions. Not only that, but you’re learning to not be emotional about investing. That money gets invested every month (or whatever time period you’ve chosen) regardless of what the overall markets are doing.
You Might Already Be Dollar-Cost Averaging
If you have a 401(k) at work, or have in the past, then you’re familiar with this concept. Remember that in order to invest in a 401(k), money is taken directly out of your paycheck. The administrator puts the money into the mutual funds and other securities that you’ve chosen. Unless your paycheck is variable, such as with commissions, this is the same amount each withdrawal period. The idea is that over time your investments will grow until you’re ready for retirement.
Drawback of Dollar-Cost Averaging
As attractive as dollar-cost averaging might be, there are reasons why it might not be the right choice for you.
Delay Putting Cash to Work
You’re probably thinking about dollar-cost averaging because you’re afraid the market will tank if you invest a lump sum. If you spread the dollar-cost averaging timeline out long enough, say 12 months, you might miss out on market gains. If you have the total amount of cash you want to invest, you might consider a shorter dollar-cost averaging runway or investing a lump sum.
In rapidly rising markets, there will be dollar cost averaging investors who wish they’d made a lump sum investment.
The Bottom Line
Dollar-cost averaging is a great way to systematically invest in financial markets. When markets are going down, it results in buying more shares at lower prices and less shares when prices are high. Put your savings on auto pilot and take the guesswork out of investing by dollar-cost averaging.