What Is Dollar-Cost Averaging? – techmirror.in

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What is dollar cost averaging?

Dollar cost averaging is the practice of investing a fixed dollar amount on a regular basis, regardless of the share price. It’s a good way to develop a disciplined investing habit, be more efficient in how you invest and potentially lower your stress level—as well as your costs.

Let’s say you invest $100 every month. When the market is up, your $100 will buy fewer shares, but when the market is down, your money will buy more. Over time, this strategy could lower your average cost per share—compared to what you would have paid if you’d bought all your shares at once when they were more expensive than the average.

How dollar cost averaging works
With dollar cost averaging

Timing Amount Share price Share purchased
Month 1 $100 $5 20
Month 2 $100 $5 20
Month 3 $100 $2 50
Month 4 $100 $4 25
Month 5 $100 $5 20
Total invested: Average cost/share: Total shares purchased:
$500 $3.70 135

The example is hypothetical and provided for illustrative purposes only.

As you can see above, dollar cost averaging enabled our hypothetical investor to take advantage of a price decline in Month 3, significantly reducing the average cost per share. Despite paying $4 or more per share in four out of the five months, the average cost per share came out to $3.70, and the investor was able to purchase a total of 135 shares.

Without dollar cost averaging

Timing Amount Share price Share purchased
Month 1 $500 $5 100
Month 2 $0 $5 0
Month 3 $0 $2 0
Month 4 $0 $4 0
Month 5 $0 $5 0
Total invested: Average cost/share: Total shares purchased:
$500 $5 100

The example is hypothetical and provided for illustrative purposes only.

By contrast, had all $500 been invested in Month 1, the average cost per share would have been $5 for a total of 100 shares.

In a perfect world, the investor would have placed all the money in Month 3 and walked away with 250 shares. However, there was no way of knowing ahead of time that this was the best time to buy, which is why dollar cost averaging is so valuable. By investing frequently and regularly over a long period of time, you’re less likely to miss out on those buying opportunities.

Benefits of Dollar-Cost Averaging

  • Dollar cost averaging can lower the average amount you spend on investments.
  • It reinforces the practice of investing regularly to build wealth over time.
  • It’s automatic and can take concerns about when to invest out of your hands.
  • It removes the pitfalls of market timing, such as buying only when prices have already risen.
  • It can ensure that you’re already in the market and ready to buy when events send prices higher.
  • It takes emotion out of your investing and prevents you from potentially damaging your portfolio’s returns.

Who Should Use Dollar-Cost Averaging?

The investment strategy of dollar-cost averaging can be used by any investor who wants to take advantage of its benefits, which include a potentially lower average cost, automatic investing over regular intervals of time, and a method that relieves them of the stress of having to make purchase decisions under pressure when the market is volatile.

Dollar-cost averaging may be especially useful to beginning investors who don’t yet have the experience or expertise to judge the most opportune moments to buy.

It can also be a reliable strategy for long-term investors who are committed to investing regularly but don’t have the time or inclination to watch the market and time their orders.

However, dollar-cost averaging isn’t for everyone. It isn’t necessarily appropriate for those investing time periods when prices are trending steadily in one direction or the other. Be sure to consider your outlook for an investment plus the broader market when making the decision to use dollar-cost averaging.

Bear in mind that the repeated investing called for by dollar-cost averaging may result in higher transaction costs compared to investing a lump sum of money once.

Special Considerations

It’s important to note that dollar-cost averaging works well as a method of buying an investment over a specific period of time when the price fluctuates up and down. If the price rises continuously, those using dollar-cost averaging end up buying fewer shares. If it declines continuously, they may continue buying when they should be on the sidelines.

So, the strategy cannot protect investors against the risk of declining market prices. Like the outlook of many long-term investors, the strategy assumes that prices, though they may drop at times, will ultimately rise.

Using this strategy to buy an individual stock without researching a company’s details could prove detrimental, as well. That’s because an investor might continue to buy more stock when they otherwise would stop buying or exit the position.

For less-informed investors, the strategy is far less risky when used to buy index funds rather than individual stocks.

Investors who use a dollar-cost averaging strategy will generally lower their cost basis in an investment over time. The lower cost basis will lead to less of a loss on investments that decline in price and generate greater gains on investments that increase in price.

Example of Dollar-Cost Averaging

Joe works at ABC Corp. and has a 401(k) plan. He receives a paycheck of $1,000 every two weeks. Joe decides to allocate 10% or $100 of his pay to his employer’s plan every pay period.

He chooses to contribute 50% of his allocation to a large cap mutual fund and 50% to an S&P 500 index fund. Every two weeks 10%, or $100, of Joe’s pre-tax pay will buy $50 worth of each of these two funds regardless of the fund’s price.

The table below shows the half of Joe’s $100 contributions that went to the S&P 500 index fund over 10 pay periods. Throughout 10 paychecks, Joe invested a total of $500, or $50 per week. The price of the fund increased and decreased over that time.

The results of dollar-cost averaging:

Joe spent $500 in total over the 10 pay periods and bought 47.71 shares.

He paid an average price of $10.48 ($500/47.71).

Joe bought different share amounts as the index fund increased and decreased in value due to market fluctuations.

The results if Joe spent one lump sum:

Say that, instead of using dollar-cost averaging, Joe spent his $500 at one time in pay period 4. He paid $11 per share.

That would have resulted in a purchase of 45.45 shares ($500/$11).

There was no way for Joe to know the best time to buy. By using dollar-cost averaging, though, he was able to take advantage of several price drops despite the fact that the share price increased to over $11. He ended up with more shares (47.71) at a lower average price ($10.48).

When is the best time to invest?

The answer to this age-old investing question is deceptively simple: when prices are low. However, trying to time the market—waiting for the best time to buy or sell an investment—is extremely difficult. Fortunately, there’s a time-tested strategy that can help you buy more when prices are lower and less when prices are higher. It’s called dollar cost averaging.

Why Might Someone Consider Dollar-Cost Averaging?

It would be great if we could buy stocks, or other types of investments, when the market is low and sell when the market is high. Unfortunately, efforts to “time the market” often backfire, and investors end up buying and selling at the wrong time.

When stocks go down, people often get fearful and sell. Then, when the market goes back up, they might miss out on potential gains. On the flip side, when the stock market goes up, investors might be tempted to rush in. But they could end up buying just as stocks are about to drop.

Dollar-cost averaging can help take the emotion out of investing. It compels you to continue investing the same (or roughly the same) amount regardless of the market’s fluctuations, potentially helping you avoid the temptation to time the market.

When you dollar-cost average, you buy more shares of an investment when the share price is low and fewer shares when the share price is high. This can result in paying a lower average price per share over time.

And by wading in, as opposed to handing over your money all at once, dollar-cost averaging can help you limit your losses in the event the market declines.

What Are the Potential Downsides of Dollar-Cost Averaging?

Dollar-cost averaging can be a helpful tool in lowering risk. But investors who engage in this investing strategy may forfeit potentially higher returns. With dollar-cost averaging, you’re holding onto your money as cash longer, which has lower risk but often produces lower returns than lump sum investing, especially over longer periods of time.

If the market goes up during a period when you’re dollar-cost averaging, you might miss out on the potential gains you could have had, had you invested right away in one fell swoop.

Of course, this doesn’t apply to something like your 401(k) because, in that situation, you’re investing the money as you earn it, not holding money in cash until a later date.

Also, keep in mind that if you engage in dollar-cost averaging, you might encounter more brokerage fees. These fees could erode your returns. And you also need to be disciplined with that money that’s sitting on the sidelines in order to actually eventually invest it and not erode it with purchases.

What’s the Bottom Line for Investors?

As is the case in all aspects of investing, it’s important to consider potential returns as well as your tolerance for risk.

Investing all of your money right away might yield higher returns than dribbling out smaller amounts over time.

But if you’re looking to reduce your risk and control your emotions, or you’re concerned about volatile market conditions, then dollar-cost averaging could be a viable strategy—even if that means forfeiting some potential upside. If your main concerns are reducing short-term downside risk and avoiding feelings of regret after a potential loss, dollar-cost averaging might be right for you.

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