There’s more than one way to invest. Besides choosing a vehicle to put your money into, you’ll need to pick an investing strategy. The one that you select will depend on various factors, including your target asset allocation and the kinds of returns you want to see. If you’ve never heard of dollar-cost averaging, we’ll review how this investing technique works.
Dollar-Cost Averaging: The Basics
So what is dollar-cost averaging? Also referred to as the constant dollar plan, it’s the process of investing a specific dollar amount in a security according to a set schedule. The number of shares you purchase each time depends on the share price.
In other words, when the share price seems high, you’ll invest a fixed amount of money in a small number of shares. When the price falls, you’ll invest the same dollar amount as before but you’ll buy more shares. Through dollar-cost averaging, you can buy a lot of shares and even as the cost per share changes, the average cost you’ll pay per share will go down with time.
Let’s look at an example. Say you want to invest $10,000 in a stock but you don’t want to invest all of that money at one time. With dollar-cost averaging, you can spread out that investment. For instance, you could invest $2,500 every three months.
When shares are cheap, you might pay $2,500 and buy 200 shares. But if the price rises in the third quarter, you could use your $2,500 and buy just 80 shares.
The Purpose of Dollar-Cost Averaging
Investing can be scary because it’s impossible to time the market perfectly. Even the most seasoned investor might not be able to predict a dip or a downturn in a particular sector. When you’re investing in something as risky as stocks, you’ll inevitably deal with volatility.
Dollar-cost averaging is a strategy that’s meant to make investing less frightening and less dramatic. Investing small amounts of money in fixed increments over time isn’t as risky as investing a large sum of money at once. And since you’re investing regularly, you don’t have be so concerned with how the market’s performing.
So going back to our example, regardless of whether there’s a bear market or a bull market, you’d invest your $2,500 in stocks each quarter if you were on a constant dollar plan. Thanks to the consistency embedded within the strategy, you can save time by automating your investments.
When Dollar-Cost Averaging Works
While you can use dollar-cost averaging to invest in everything from stocks and bonds to mutual funds, it won’t work well with every single asset.
It’s best to use this strategy when you’re investing in a security whose prices often fluctuate. For example, dollar-cost averaging can be beneficial to someone who’s buying ETFs, mutual funds or stocks. On the other hand, it’s not so helpful for folks investing in securities like bonds.
Dollar-cost averaging is also most effective when someone’s investing over a long period of time. What’s great about it is that you can save money by buying up a bunch of shares when prices are low, just like you can save by purchasing paper towels or laundry detergent in bulk when they’re on sale. And since you’re charged a certain percentage for buying shares, buying fewer shares at one time means you could pay fewer fees.
If you’re only investing for a couple of months, however, share prices won’t change that much and dollar-cost averaging won’t be so beneficial.
The Drawbacks of Dollar-Cost Averaging
There are disadvantages to using a constant dollar plan. For one, no one can say for certain that’ll you’ll build a large amount of wealth.
If you put your investments on autopilot, you might miss out on the chance to buy additional shares that could increase your earnings when you sell them off. On the flip side, you could be unknowingly investing in a security whose prices are actually remaining stagnant or dropping consistently. If you’re not routinely reviewing your portfolio (and you’re not paying any attention to the markets), a whole year or two could go by before you realize you’ve lost money.
Some experts say that in terms of stocks, for example, the market has seen more good times than bad times. So you could be sacrificing some significant gains by trying to play it safe with dollar-cost averaging instead of investing lump sums of cash. Having a diverse mix of assets in your portfolio that you switch out when necessary might be a better way to keep your risk to a minimum and maximize your returns.
Dollar-cost averaging is just one investing strategy that you can implement. It can be a useful method for someone who doesn’t have a lot of spare change to invest at once or doesn’t have time to monitor the markets. But it might not be the best technique for you if you’re investing for a short period of time or you can afford to use a riskier strategy that could offer you higher returns.
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