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Dollar cost averaging is an investment strategy that spreads investments out over time to help blunt the effects of stock market volatility and build wealth. It's especially geared to beginners and investors who don't have the time or inclination to watch for the perfect time to invest.
To put the concept into a familiar context: You may harbor some regret if you've ever bought something from a store only to see it go on sale right after. If you had waited, you could have bought the item for the lower price. Conversely, you might count it as a victory if you bought an item the day before a price increase.
This same fluctuation occurs when it comes to stock prices—though in this case it can cost you a lot more than a few dollars' difference on a new belt or coffeemaker. If you're not a full-time investor, you may want a strategy that limits your exposure to rapid changes in the markets but still gives you a good opportunity to build your investment. Read on to learn how dollar cost averaging works and to see if it could be a good strategy for you.
How Does Stock Investing Work?
The stock market is constantly in flux: The value of an individual stock or mutual fund can vary throughout the day, week, month and year. Stock prices are based on market demand, and a stock's price will change according to how many investors want to buy or sell that stock at a given time.
To use the stock market to build wealth, you'll need to buy an investment (shares in a given company or a mutual fund that invests in several companies) when the price is low and sell it later for a higher price.
This may seem easy enough, but it's often difficult to predict whether a stock or mutual fund will increase or decrease in value. Trying to time the market is challenging even for experienced investors, but for those with less experience, emotions can sometimes get in the way of making sound investment decisions. That's where dollar cost averaging can be especially helpful.
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How Does Dollar Cost Averaging Help?
Dollar cost averaging spreads an investment in a stock or mutual fund over time instead of investing a lump sum all at once. The idea is that by spending a set dollar amount at a regular interval—say, every other week or once a month—your investment will be insulated from market swings and allow you to buy more shares when an investment's value is low and fewer when the value is higher.
Dollar cost averaging also helps remove the emotional aspect of investing. When it comes to your money, it's easy to react impulsively if you think a change will help you make more money or, alternatively, reduce your losses. By creating a set investment that occurs regardless of market conditions, you are effectively removing the emotional control you might have otherwise exerted—which could prove valuable over the long run.
How Does Dollar Cost Averaging Work?
To see dollar cost averaging at work, let's imagine you have $1,000 you want to invest in a certain stock. For this example, let's say the stock you're buying is called CRDIT.
Scenario 1 (Lump sum investment): In this scenario, you take your $1,000 and invest it all at once, buying 20 shares of CRDIT at $50 each. As long as you hold this stock, your purchase price for these shares will be $50. If the cost of a CRDIT share goes up to $51, your position will increase by $20. If CRDIT goes down to $48, your total position will decrease by $40.
Scenario 2 (Dollar cost averaging): In this example of dollar cost averaging, you take your $1,000 and split it into 10 portions of $100 that you plan to invest once a week. Each week at the same time, you buy $100 worth of CRDIT at whatever the price is that day.
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After five weeks, you can already start to see a pattern emerge. You've spent the same set amount on CRDIT, and each week the value of the stock changes. Over the course of five weeks, you've purchased more shares of CRDIT at a cost cheaper than $50, thus bringing the average price for each share during that period to $48.20.
Over time, the hope is that the price of CRDIT rises. As the price rises over $50, all of the shares you bought for under $50 add to the return on your investment. Conversely, if you only invested in a lump sum at $50 a share, you won't get the benefit of buying more shares at lower prices.
Should I Consider Dollar Cost Averaging?
If you want to invest in the stock market but want to limit your risk, dollar cost averaging is a strategy that could benefit you. Anyone can use a dollar cost averaging strategy—and you may already be doing so if you invest a set amount in your company's 401(k) plan every month. It is also often used by beginner investors or by investors looking to limit their exposure to market volatility.
As opposed to investing a large sum all at once, it reduces the chance you'll invest when a stock or fund is at a high point or miss out on an even lower price. It also allows you to work within your budget to find an amount you can afford to invest over time rather than trying to come up with one larger lump sum.
For help making investing decisions, consider contacting a financial professional to get input on your specific situation. Another way to mitigate your risk if you're not a professional investor is to invest in an index fund (which follows a given market index, such as the S&P 500) or mutual fund that invests in many different companies rather than choosing one stock for your investment.
How to Implement a Dollar Cost Averaging Strategy
Creating your own dollar cost averaging strategy is simple: Just take the amount you want to invest and divide it into equal portions to be invested over a period of time, or just decide on an amount to invest and set up a schedule (you don't have to have an end date if you don't want one). You can do this each week, each month or each payment period—whatever is best for you.
Once you set the intervals and establish the amount you plan to invest, make sure you set up an auto-transfer or direct deposit so you don't have to remember to do it manually each time. If you have a brokerage account, you can set up an auto-funding option at the interval of your choice.
Be sure to use a spreadsheet or other method to track each of your contributions. This will help you be able to look back to see if this strategy worked over time. Track things like the purchase price for each share in each interval, the date of purchase and the number of shares purchased.
Investing Is Just One of Many Financial Strategies
Remember that investing is just one aspect of your overall financial strategy. Before investing, you'll want to make sure you have a steady income, ample savings and aren't struggling to manage your debt. If you have debt, it may be good to pay down debt before you start investing.
The one exception is investing in your retirement, which you should aim to do as early as possible, even if you can only set aside a small amount each month in the beginning.