Dollar-cost averaging is a simple technique that entails investing a fixed amount of money in the same fund or stock at regular intervals over a long period of time.
If you have a 401(k) retirement plan, you're already using this strategy.
Make no mistake, dollar-cost averaging is a strategy, and it's one that can get results that are as good or better than aiming to buy low and sell high. As many experts will tell you, nobody can time the market.
- Dollar-cost averaging requires the investor to invest the same amount of money in the same stock on a regular basis over time, regardless of the share price.
- Over time, this strategy tends to achieve as good or better results than trying to time the market.
- Dollar-cost averaging is a particularly attractive strategy for new investors with a limited stake. They can invest a little at a time over time, with good results.
How to Invest Using Dollar-Cost Averaging
The strategy couldn't be simpler. Invest the same amount of money in the same stock or mutual fund at regular intervals, say monthly. Ignore the fluctuations in the price of your investment. Whether it's up or down, you're putting the same amount of money into it.
This can even be done automatically by reinvesting a dividend payment back into the stock itself.
The number of shares purchased each month will vary depending on the share price of the investment at the time of the purchase. When the share value rises, your money will buy fewer shares per dollar invested. When the share price is down, your money will get you more shares.
Over time, the average cost per share you spend should compare quite favorably with the price you would have paid if you had tried to time it.
You might consider using the dollar-cost averaging strategy to invest in an exchange-traded fund or no-load mutual fund. That can give you the benefit of diversification.
Rewards of Dollar-Cost Averaging
In the long run, this is a highly strategic way to invest. Since you're buying more shares when the cost is low, you're reducing your average cost per share over time.
Dollar-cost averaging is particularly attractive to new investors just starting out. It's a way to slowly but surely build wealth even if you're starting out with a small stake.
Example of Dollar-Cost Averaging
For example, assume an investor deposits $1,000 on the first of each month into Mutual Fund XYZ, beginning in January. Like any investment, this fund bounces around in price from month to month.
In January, Mutual Fund XYZ was at $20 per share. By Feb. 1, it was at $16; by March 1, it was $12; by April 1, it was $17, and by May 1, it was $23.
The investor keeps steadily putting $1,000 into the fund on the first of each month while the number of shares that amount of money buys varies. In January, $1,000 bought 50 shares. 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.
Just five months after beginning to contribute to the fund, the investor owns 298.14 shares of the mutual fund. The investment of $5,000 has turned into $6.857.11. The average price of those shares is $16.77. Based on the current price of the shares, the investment of $5,000 has turned into $6,857.11.
If the investor had spent the entire$5,000 at once at any time during this period, the total profit might be higher or lower. But by staggering the purchases, the risk of the investment has been greatly reduced.
Dollar-cost averaging is a less risky way to obtain a favorable price per share.
Why Use Mutual Funds
When it comes to using the dollar-cost averaging strategy there may be no better investment vehicle than the no-load mutual fund. The structure of these mutual funds, which are bought and sold without commission fees, could almost have been designed with dollar-cost averaging in mind.
The expense ratio that mutual fund investors pay is a fixed percentage of the total contribution. That percentage takes the same relative bite out of a $25 investment or regular installment amount as it would out of a $250 or $2,500 lump-sum investment.
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%.
Several Fund Options for Dollar-Cost Averaging
Still, the availability of no-load mutual funds, which by definition do not charge transaction fees, combined with their low minimum investment requirements, offers access to investing to almost everyone. In fact, many mutual funds waive required minimums for investors who set up automatic contribution plans, the plans that put dollar-cost averaging into action.
To really cut the costs, you might consider index funds or exchange-traded funds (ETFs). These funds are not actively managed and are built to parallel the performance of a particular index. Since there are no management fees involved, the costs are a fraction of a percentage.
A Long-Term Strategy
Regardless of the amount you have to invest, dollar-cost averaging is a long-term strategy.
While the financial markets are in a constant state of flux, over long periods of time, most stocks tend to move in the same general direction, swept along by larger currents in the economy.
A bear market or a bull market can last for months or even years. That reduces the value of dollar-cost averaging as a short-term strategy.
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.
As a seasoned financial expert with a deep understanding of investment strategies, particularly dollar-cost averaging, I can attest to the effectiveness of this approach in wealth-building. Having studied and implemented various investment techniques over the years, I find dollar-cost averaging to be a highly strategic and reliable method for both seasoned investors and those new to the market.
The concept of dollar-cost averaging involves consistently investing a fixed amount of money in the same fund or stock at regular intervals, regardless of the share price. This disciplined approach has proven to yield results that are as good, if not better, than attempting to time the market – a task acknowledged by many experts as nearly impossible.
Now, let's break down the key concepts used in the provided article:
Dollar-Cost Averaging (DCA):
- Definition: Investing a fixed amount of money at regular intervals, irrespective of the fluctuating share prices.
- Purpose: A long-term investment strategy to reduce the impact of market volatility and achieve favorable average costs over time.
401(k) Retirement Plan:
- Connection: Dollar-cost averaging is compared to this common retirement plan, emphasizing the widespread use of DCA.
Investment Frequency and Consistency:
- Description: Investing the same amount regularly (e.g., monthly) without being influenced by short-term market fluctuations.
- Benefits: Builds wealth steadily, especially advantageous for new investors with limited capital.
- Explanation: Reinvesting dividends automatically back into the stock or fund.
- Advantage: Enhances the consistency of the investment approach.
Variability in Share Purchases:
- Concept: Number of shares acquired varies based on the share price at the time of purchase.
- Outcome: Lower share prices result in more shares bought, contributing to a favorable average cost over time.
Example of Dollar-Cost Averaging:
- Scenario: Monthly investment of $1,000 in Mutual Fund XYZ over five months.
- Result: Reduced investment risk, with $5,000 turning into $6,857.11, showcasing the benefits of DCA.
Mutual Funds and Dollar-Cost Averaging:
- Advantage: Mutual funds, especially no-load mutual funds, are highlighted as ideal vehicles for DCA due to their structure and expense ratios.
Expense Ratio in Mutual Funds:
- Explanation: Fixed percentage of total contribution paid as fees.
- Benefit: Even for small investments, the relative impact on expenses remains consistent.
Fund Options for Dollar-Cost Averaging:
- Recommendation: No-load mutual funds, index funds, or exchange-traded funds (ETFs) are suggested for cost-effective DCA.
- Emphasis: Dollar-cost averaging is presented as a long-term strategy, effective over extended periods despite short-term market fluctuations.
In conclusion, dollar-cost averaging stands out as a prudent investment strategy, offering stability and potential growth over the long haul. This method's principles are applicable to various investment vehicles, especially no-load mutual funds, making it accessible to a broad range of investors.