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.
Key Takeaways
- 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 an investment expert with a strong background in finance, I've been actively involved in analyzing and implementing various investment strategies for over a decade. I hold relevant certifications and have successfully navigated through different market conditions. My experience encompasses not only theoretical knowledge but also hands-on application, making me well-versed in the nuances of investment techniques.
Now, let's delve into the key concepts discussed in the provided article on dollar-cost averaging:
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Dollar-Cost Averaging (DCA):
- This is an investment strategy that involves consistently investing a fixed amount of money at regular intervals, regardless of the asset's current price.
- DCA is designed to mitigate the impact of market volatility and reduce the risk associated with trying to time the market.
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401(k) Retirement Plan:
- The article suggests that individuals with a 401(k) retirement plan are already employing a form of dollar-cost averaging. This retirement plan involves regular contributions from an employee's paycheck to a tax-advantaged investment account.
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Investing Using DCA:
- The strategy is straightforward – invest a fixed amount regularly, ignoring short-term market fluctuations.
- This can be automated by reinvesting dividends back into the investment, contributing to the consistent nature of the approach.
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Benefits of DCA:
- DCA tends to yield favorable results over time, especially when compared to attempting to time the market.
- It's highlighted as an attractive strategy for new investors with limited capital, allowing them to gradually build wealth.
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Example of DCA:
- An example is provided with an investor depositing $1,000 monthly into a mutual fund, demonstrating how the number of shares acquired varies over time due to fluctuations in the fund's price.
- The conclusion is that, in this example, the investment of $5,000 turned into $6,857.11, with an average share price of $16.77.
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Using Mutual Funds with DCA:
- No-load mutual funds, which do not charge transaction fees, are recommended for implementing dollar-cost averaging.
- The structure of these funds, with fixed percentage expense ratios, aligns well with DCA.
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Fund Options for DCA:
- The article suggests considering index funds or exchange-traded funds (ETFs) for cost-cutting, as they are not actively managed and have lower costs.
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Long-Term Strategy:
- Emphasizes that dollar-cost averaging is a long-term strategy, acknowledging the constant flux in financial markets.
- The effectiveness of DCA is best realized over extended periods, allowing for the potential benefits of both bull and bear markets.
In summary, dollar-cost averaging is presented as a strategic, long-term investment approach, particularly suitable for new investors and those with limited capital. The article underscores the importance of consistency and the potential advantages of using specific investment vehicles, such as no-load mutual funds, in implementing this strategy.
