Should I get back in the Stock Market all at Once?
A recent reader emailed me with this question, as they moved their 401k into cash in the first of January. Basically, they would like to have equity exposure in hopes of getting higher returns, but are extremely uncomfortable taking the plunge all at once. My answer, almost without hesitation, was to invest using dollar cost averaging.
What is Dollar Cost Averaging?
Per Wikipedia, Dollar cost averaging is a timing strategy of investing equal dollar amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
How to Set Up your Own Dollar Cost Averaging Plan
Three things to think about in setting up your Dollar Cost Averaging Plan are:
- Decide exactly how much you can invest each month. To make the plan the most effective, you will need to invest the same amount.
- Decide on the investment that you would like to own. Whether it is an individual stock, mutual fund, or ETF, make sure that it is something that you will hold for at least a number of years.
- Invest the predetermined amount into the security you’ve picked. It helps quite a bit if you have some sort of automatic investment program to ensure that you stick to your plan.
Real Life Example of Dollar Cost Averaging using an Individual Stock
In this example, you can see where the investor decide to make a $2500 investment 4 times a year, with the same security and predetermined amount. Over the 3 year period, as the investments continue, the average cost of the stock purchased ended up being $20.10, as opposed to getting all in at $56.72, which would have resulted in a nearly 80% loss over the period. By averaging out the purchases, you actually decrease the amount of risk at stake, as evidenced above.
Dollar Cost Averaging is only disadvantageous in the stock or mutual fund that is going straight up over the 3 year period. However, even in an up market, you would still realize quite a return, while mitigating quite a bit of risk.
