Dollar Cost Averaging 101
Dollar cost averaging —is an investing technique intended to reduce exposure to risk associated with making a single large purchase. The idea is simple: spend a fixed dollar amount at regular intervals (e.g., monthly) on a particular investment or portfolio/part of a portfolio, regardless of the share price. In this way, more shares are purchased when prices are low and fewer shares are bought when prices are high. The premise of dollar cost averaging is that the investor wants to guard against the market losing value shortly after making his investment. Therefore, he or she chooses to spread their investment over a number of periods.
Everyone knows the market goes up and down.
A common adage is to "buy low and sell high." Trouble is, it's next to impossible to know exactly what the market will do in the near future. What's more, most individuals don't have the discipline or courage to try to time the market. People who watch the market tend to put money in when it goes up and never put it in when it goes down. Or if the market's gone up, they're afraid they've missed it and they don't do anything.
That's where dollar-cost averaging comes in.
It's a discipline that reduces risk, not something to get rich quick.
It's a technique whereby you invest a set amount of money on a systematic schedule over the long haul regardless of how the market is performing. Because you've put your investing on autopilot, you'll end up with more shares for your money when the market is down. But if stock prices rise, you wind up with fewer shares.
Pros of Dollar Cost Averaging
Affordability. Dollar cost averaging is more affordable and allows people to treat investing like paying a bill. It is difficult for most people to invest a $5,000 lump sum to max out a Roth IRA or Traditional IRA. However, many people may be able to afford a monthly installment of $416.66, which will put them on pace to max out their IRA for the year.
A similar example is investing in a 401(k) plan, which is deducted directly from your paycheck. Even if you could afford to invest the $15,500 limit at the beginning of the year from your cash savings, your paycheck wouldn’t be large enough to cover that. Most people also rely upon their paycheck to pay bills throughout the month. A 401(k) plan forces the participant to use dollar cost averaging.
Convenience. It is easy to set up dollar cost averaging as a monthly payment and incorporate it into your budget.
Cons of Dollar Cost Averaging
Lump sum investing can result in better returns. Lump sum investing can often result in better returns because you have your money in the market longer. This is based on the idea that the longer you have your money in the market, the better your returns are over the long run.
More fees. Dollar cost averaging also means making more transactions, which can result in higher brokerage fees. You won’t pay these fees if you are investing in a 401(k), but you could if you were making monthly purchases of a stock or mutual fund. You can mitigate these fees by investing quarterly or semi-annually.
Final Thoughts
As you can see, dollar cost averaging is more of an investing technique that forces you to implement a steady strategy, and tends to take the emotion out of when to invest. There will always be times that you think that the market will either go lower, or higher, but this forces you to keep more of a long term perspective.
