What Is Dollar-Cost Averaging?
A popular investing technique, dollar-cost averaging increases returns in the long run. Instead of investing in one particular asset at a set price, the goal of dollar-cost averaging is to divide the amount of money you plan to invest and to purchase small quantities over a longer period of time, paying whatever the current price is at any given time.
Doing so will minimize the chances that you'll pay more for an investment that is going to drop in price soon. If you divide your money and engage in multiple buys, you subsequently maximize your chances of paying less, on average, over time.
The bonus is that your money starts working for you on a consistent basis, which ultimately leads to long-term growth, while reducing the impacts of unwanted volatility.
If you have a 401(k), then you are likely already implementing the investment strategy of dollar-cost averaging, potentially without even realizing it. You may have selected a predetermined percentage of your salary to invest in your 401(k), which is likely being put toward mutual funds or index funds.
How does dollar-cost averaging work?
Over time, the prices of assets often rise, though the increases are not consistent. That means they are difficult, if not impossible, to predict. Many prices do not follow any predictable patterns, and dollar-cost averaging works with that fact rather than against it.
Trying to predict the market and determine the best times to purchase, especially by buying assets when prices are low, is almost impossible, even for professional stock pickers. Nobody knows how the market will change, so attempting to predict it is a losing battle. Today's low could be tomorrow's high, or vice versa, but there is no way to know for sure.
You need time to see what the most favorable prices would be for any asset. Of course, by then, it's already too late to buy. In attempting to time your purchase, you may end up purchasing at a price that has already plateaued after it made its big gains.
Research conducted by Charles Schwab found that investors who have tried to time the market witnessed fewer gains than investors who regularly invested using the dollar-cost averaging strategy. But what's the secret?
It all comes down to the fact that dollar-cost averaging removes the emotional aspect from the investing process. You simply invest the same small amount of money on a regular basis, and in time, it adds up. Plus, you'll end up buying far fewer shares when prices are high and a lot more when prices are low, which is ideal.
You'll ultimately save money on each share that you purchase by spreading out your investments over the course of one year as opposed to how much it would cost to invest all of your money at once. With dollar-cost averaging, you'll purchase more shares at a lower price per share, on average. In turn, when the mutual fund, for example, increases in value over time, you'll own more shares in this valuable investment.
If you do not have a lot of money to invest all at one time, dollar-cost averaging can help you put your money into stocks and market shares more consistently. Instead of waiting until you have saved up hundreds or thousands of dollars, dollar-cost averaging allows you to participate in market growth earlier. In turn, you will avoid investing a large amount of money at a time that is not advantageous or is less than ideal from an investment point of view.
Since it is not possible to predict drops in the market, the strategy of dollar-cost averaging reduces your investment risks while increasing your odds of seeing impressive returns. If you're just starting out in the world of investing and you have lower amounts of money to put toward share purchases, dollar-cost averaging might be for you.
It's also ideal for people who don't know how to time the market. Additionally, if it's unlikely on a psychological level that you'll keep investing in down markets, this may be the best way for you to enjoy growth in the future.