It's among the trickiest questions investors face: When the market is volatile, what should I do?
You know you ought to keep investing for the future, but it can be tempting to stay on the sidelines. No one wants to invest a bunch of money only to watch its value plunge along with the market the next day. Do you buy now, or buy later?
The short answer is, both.
In fact, investing has a technical term for this smart strategy: dollar-cost averaging.
Here’s how the concept plays out:
Say you have $1,000 you want to invest in mutual funds. You could put it all in right now, and accept the risk that your investment could take a steep decline. Or you could split it up into smaller chunks—say, four sets of $250—to invest over time. If the price of the fund goes down after your first investment, that's good news! With your second lot of $250, you'll be able to buy more shares—it's on sale.
Over time, dollar-cost averaging has the effect of "smoothing out” the price of an investment. When you split the purchases over several weeks or months, you are essentially buying the stock at an "average" price during that span. So long as the long-term prospects for your investment are good, you'll be glad that you split up your purchases this way.
It’s easy to take advantage of this strategy. In fact, you’re probably already doing so if you contribute to a 401(k) at work or have set up automatic recurring transfers into an IRA, 529 college savings plan, or other investment account.
(If you want to road test it, Merrill Edge has a dollar-cost averaging calculator that lets you play with different scenarios.)
Dollar-cost averaging isn’t just a smart financial play. It helps take emotions out of the purchase so that you don’t make impulsive decisions ruled by either fear or greed, says C.J. Brott, founding partner of Alliance Financial Group, an investment firm in Dallas. He tells clients to use the strategy because it helps them "make an emotional commitment" to investing.
"Given the uncertainties in this economic environment, it’s very difficult for a novice investor to follow a disciplined program," Brott says.
But it’s not a magic formula, warns Desmond Henry, a Topeka, Kansas-based certified financial planner.
In one Financial Planning Association study, lump-sum investing beat dollar-cost averaging two-thirds of the time. Why? In general, maximizing the time your money can marinate in the market is the best way to achieve long-term gains, Henry says. Dollar-cost averaging keeps some of your money on the sidelines for a bit longer, and when you crunch the numbers, that can hurt more than it helps.
In our example above, if the market rose after our investor’s first purchase, he could end up losing out compared with throwing all that money into the market upfront.
Still, Henry says, dollar-cost averaging is a great strategy for investors who might be a little nervous—which is to say, pretty much everyone.
"Don’t write off the psychological value dollar-cost averaging can have helping investors sleep better at night," he said. "While everybody knows you’re supposed to buy low, mustering up the courage and discipline to do so during volatile markets can be difficult.”
Bottom line: If you know you should invest, but are worried about bad luck or bad timing, dollar-cost averaging via regular, automatic contributions to a 401(k) or other investment account is a sensible way to lower that risk and get started building your wealth for the future.
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