What is Dollar Cost Averaging & How it Works for You
Many investors find the concept of Dollar-Cost Averaging confusing, but it is very useful as a strategy for investing. Dollar-cost averaging is where an individual periodically invests a set amount of dollars into a fluctuating investment – typically a mutual fund - over time. This is typically done in 401k plans, but can also be done in IRAs or Individual Brokerage accounts. Purchases are made automatically, regardless of how the market is performing at the time. The strategy allows an investor to get an average investment cost that is lower than the average price of the shares over that period of time.
You may be thinking, “Cost lower than price? What’s the difference?” Cost is what the investor spent over the life of an investment. The average price, on the other hand, is what the shares of the fund were worth, on average, over the life of a fund. Using dollar-cost averaging, you can accumulate shares at an average cost that is lower than the average price of the investment – potentially creating a higher return for the investor than the actual performance of the underlying investment, increasing your profitability and return.
This strategy is advantageous for new investors or those who don’t have a large lump sum to invest right away. You deposit an amount you’re comfortable with every period (typically monthly) and the money gets invested automatically. An example of this is a 401k plan. Say your salary is at $80,000 and you invest, 5% per year on a monthly basis, so you’re investing roughly $270 per month. Now, let’s say you choose one fund to invest all this money into (*not recommended, but for simplicity’s sake we will use one). The first month you purchase, the fund costs $20 so you can buy 13.5 shares, second month it costs $24 (11.25 shares), third month $22 (12.27 shares), fourth $18 (15 shares) and fifth $20 (13.5). In total you would now own 68.52 shares and paid $1350 for them - an average cost of $19.70 per share. The average price of those shares, however is $20.80 – and, oddly enough, the actual performance of the fund over this period of time is 0% (it started at $20 and ended at $20), but the investor’s shares are worth $1370 - $20 more than was paid. While $20 may not seem like much now, imagine this strategy played out month after month, year after year.
Many investors tend to wait until they have large lump sums to invest and put it all in at once. However, if a decision is made to invest a small amount every month, the volatility of the stock market can turn into a benefit instead of a risk. As a matter of fact, when the market is down, the dollar-cost average investors are benefiting by getting more shares for the exact same amount of money they invested when the market was up. Essentially, this strategy is to invest money as soon as it becomes available (Paychecks, social security checks, disability, etc.).
Now, be sure not to confuse dollar-cost averaging with market timing or changing asset allocation. With market timing, you may invest periodically as well, but not at an automatic/cyclical pace; you invest when you decide the investment is worth it. Same thing with asset allocation. If you have a large lump sum and you choose to invest it over time by increasing your risk tolerance every month or so, that is not the same as dollar-cost averaging and will not have the same outcome.
One thing that you must keep in mind when using dollar-cost averaging is that this is a long-term strategy. You must ride the ups as well as the downs for it to pay off. You will not see as big of a reward if you continue to change your investment lineup out of fear. This strategy will only work if you stick with it and let it do its job.
IMPORTANT DISCLOSURE INFORMATION
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