You may not have heard of “dollar-cost averaging,” but there’s a good chance you’re using that method to invest. And that’s a good thing.
It can reduce the average price you pay per share when you invest in the stock market.
What’s dollar-cost averaging?
It’s just the practice of investing a specific amount of money on a regular schedule—say, weekly, biweekly or monthly. So, when prices are high, you purchase fewer shares, and when prices are low, you can purchase more shares. That means that over time you can lower your average cost per share compared to what you may have paid if you bought all shares at once.
“If you invest regularly, you’re dollar-cost averaging,” says Certified Financial Planner Gary Silverman, founder of Personal Money Planning in Wichita Falls, Texas. the practice of investing a specific amount of money on a regular schedule—say, weekly, biweekly or monthly. When prices are high, you purchase fewer shares, and when prices are low, you’ll be able to afford more.
What are the advantages of dollar-cost averaging?
Regularly investing a set amount has a few benefits. First, it allows you to put your money to work as soon as you earn it. Because you don’t need to save up a lump sum to invest all at once, it’s much easier to get started.
Second, by investing regularly and at varying prices, you increase your potential to profit—even if an investment’s long-term returns are relatively flat, says Silverman. For example, let’s say that shares of an ETF cost $20 on January 1 as well as December 31. In all likelihood, over the course of the year, that price has fluctuated. But by purchasing more shares when the price is lower and fewer when it is higher, you could be capturing some gains that you would have missed out on had you invested all at once at the start of the year.
Take this hypothetical chart, for example, where the stock price sits at $20 for three months out of the year, dips below $20 for seven and only increases for two months:
|Month||Share Price||Shares Purchased With $1,000|
As a result, the average share price is actually $18.88—meaning the average amount you paid for a share is $1.12 (or more than 5 percent) less than what you’d pay if you invested the full $12,000 in January. Yes, share prices could have risen a lot in between those two dates instead, and you may have ended up paying a little more on average than you would if you’d gotten lucky with your timing and picked up all your shares at $20. But trying to time the market is extremely hard and often a losing proposition.
Finally, dollar-cost averaging can help take the emotion out of investing. While it can be tempting to panic-sell when the market drops, doing so can mean you end up making a common mistake: selling low and locking in losses, then buying high as the stock recovers. Locking into a disciplined approach with dollar-cost averaging can help you stay the course, even in volatile times.
“People have a tendency to feel more comfortable investing if the market has been going up for quite a while and feel less comfortable after it has gone down. But this is generally the exact opposite of what you should be doing,” Silverman says. “Dollar-cost averaging allows investors to get past this tendency.”
Of course, dollar-cost averaging doesn’t guarantee you’ll make a profit or never lose money—no strategy can do that. But it’s a smart way to take advantage of the market’s natural fluctuations and start establishing good investing habits.
October 11, 2016