Dollar cost averaging is a strategy that allows for gradual investments into one or more securities over time. An equal dollar amount is invested each period, regardless of the direction of the stock market or the individual security.
What Is Dollar-Cost Averaging?
Dollar cost averaging occurs when an investor buys the same dollar amount of a security at regular intervals, for example monthly. This strategy can be used to purchase individual stocks, ETFs, mutual funds and other investments.
The reasoning behind dollar-cost averaging is that this imposes a discipline on investors to continue to buy shares over time regardless of short-term price movements. When the price drops, the same dollar amount will result in the purchase of more shares. When the price is higher fewer shares will be purchased. Over time, if the general trend on the security is up, then the investor has the opportunity to accumulate a sizable position in the holding.
How Does Dollar-Cost Averaging Work?
An investor interested in dollar-cost averaging would need to set this up.
This is essentially the strategy inherent when contributing to an employer-sponsored retirement plan like a 401(k) or 403(b). You establish a salary deferral rate and also where these contributions are to be directed. Unless you change these instructions or your salary changes, you will be buying the same amount of each investment option that you select each pay period.
There are options outside of a 401(k) plan as well. Many mutual fund companies and investment custodians can assist you in setting this up for the mutual fund(s) of your choice. In any event, you would set up the dollar-cost averaging into the security for the same amount every month or at whatever interval is appropriate for you.
Many mutual funds offer the option to reinvest distributions from dividends and capital gains; this is another form of dollar-cost averaging.
Dollar-cost averaging can be done over any time period the investor chooses; it is best used as a long-term strategy. The benefits of consistently investing at regular intervals can accrue over time. Retirement accounts like a 401(k) are a classic example of how beneficial this can be. An investor who commits to investing each pay period over the course of their working career has a good shot at ending up with a significant nest egg at retirement. This is especially true if they increase the amount they defer on a regular basis and use an asset allocation that is consistent with their time horizon, risk tolerance and is tied to their goals.
While dollar-cost averaging might seem like a set-it-and-forget-it strategy, you will still want to monitor your holdings. Whether it's an individual stock, a single mutual fund or ETF or several holdings within a 401(k) account or other type of account, you need to monitor things and adjust as needed.
This might entail switching to another security if you've accumulated enough in the single security you've been dollar-cost averaging into, or periodically rebalancing several holdings that you are dollar-cost averaging into within your 401(k) or elsewhere.
What Are the Advantages of Dollar-Cost Averaging?
Dollar cost averaging can offer advantages for investors, including:
- Dollar-cost averaging takes the emotion out of investing. There is no decision to be made as to whether to invest that month or not. It's easy for investors to get caught up in the emotions of the stock market. If the market is trending up, investors may feel upset and feel like they have missed out, prompting them to invest more so they don't miss out on the next uptick. When the market experiences a correction, investors may feel fear that the drop will never stop and want to avoid the stock market.
- Dollar-cost averaging avoids trying to time the market. Investors are generally notoriously bad at timing the stock market. Invariably they find themselves investing at the wrong time. For long-term investors it's about time in the market, not timing the market.
- For investors who don't have a lump-sum to invest all at once, dollar-cost averaging offers a steady, disciplined approach to building wealth over time. Dollar-cost averaging can be done with a single security or several to try to build a diversified portfolio over time.
What Are the Drawbacks of Dollar-Cost Averaging?
Dollar cost averaging has many advantages, but there are some potential drawbacks as well.
- The market tends to rise over time, if you are able to invest a lump-sum early on you may benefit from the tendency of the market to rise over time to a greater extent than by investing smaller amounts gradually over time.
- Dollar-cost averaging is not a substitute for identifying solid investments. You still need to do your research and identify the right investments for you, whether these are mutual funds, ETFs, individual stocks, etc.
Example of Dollar-Cost Averaging
Here is an example of how dollar cost averaging might work.
The investor invests $100 per month in ABC mutual fund. Here how this might look over the course of a year.
Price per share
In this instance, the investor has invested $1,200 and their investment is worth $1,719.52 after making 12 equal investments. There, of course, is no guarantee that your holding will be worth more than what you paid for it.
In this example we ignored any fund distributions in our calculation - they would either be reinvested in the fund or distributed as cash to the investor.
Dollar-cost averaging offers many advantages for investors, especially those who want to invest consistently over time without having to perform a great deal of market analysis. It's not a perfect strategy, but it can work for many investors.
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