Dollar Cost Averaging Basics
Dollar cost averaging is a technique used in investing that is primarily intended to reduce risk that comes with making a lump sum investment. The idea of dollar cost averaging is very simple. You make the commitment to invest a fixed dollar amount at regular intervals (monthly, for example) on a particular investment or portfolio, regardless of how the investment is performing. By doing so, more of the shares are purchased when price of the investments are low and concurrently, fewer shares are bought when prices are inflated.
The underlying theory of dollar cost averaging is to prevent the investor from losing a large portion of the value shortly after making their initial investment. In proceeding with this strategy, the investor chooses to spread their investment over a period of time, with a regular schedule.
Dollar cost averaging helps when markets go up and down.
Everyone has undoubtedly heard the old stock market saying of "buy low and sell high." However, to the best of my knowledge, nobody has a crystal ball to predict exactly when these changes are to take place. In addition, one of the basic premises of investing for your retirement is to buy for the long haul, and not to try to time the market. More often than not, people fail miserably when trying to time the market, since it never seems like the perfect time to invest. Dollar cost averaging prevents these mistakes from taking place.
Reducing portfolio risk is the main purpose
Since dollar cost averaging is on a set schedule geared towards the long haul, you will be making investments regardless of how the market is performing. Since you are making your investments on a routine, odds are that you'll end up with more value for your money when the market is down, but on the flip side, if stock prices rise, you wind up with fewer shares. However, in looking back at real client returns, those who were on a dollar cost averaging schedule tend to be better off more often than not.
Dollar cost averaging advantages
Dollar cost averaging is much more affordable than writing a large lump sum check. A majority of people do not have the means to make a $5,000 lump sum contribution in order to max out a Roth IRA or Traditional IRA. However, a monthly installment of $416.66, which will enable them to fully fund their IRA for the year is much more doable. 401k plans are another great example of dollar cost averaging because your investment is deducted directly from your paycheck on a fixed schedule.
Even more so than an IRA, investing the $15,500 max at the beginning of the year from your own pocket is something that isn’t easily done since many people have other needs for their savings. As a result, a 401k plan forces a participant to take advantage of dollar cost averaging. Finally, it is extremely easy to set up a dollar cost averaging strategy as a monthly payment, and plan accordingly each month.
Cons of dollar cost averaging
In some scenarios, you would time the market in a positive way and end up with more money long term as a result, as lump sum investing can result in better returns due to the fact that you had all of your money in the market longer. Dollar cost averaging also means making more transactions, which can result in higher brokerage fees since you are constantly paying commissions, or incurring back end charge schedules.
If you are investing in a 401k, odds are that you will not be concerned with these fees, but it could be a factor if you were making regular investments of a particular stock or mutual fund. A good way to cut down on your exposure to fees would be to invest on a quarterly, or semi-annual basis.
Dollar cost averaging recap
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 dollar cost averaging forces you to keep more of a long term perspective.
