Dollar cost averaging explained, with examples

When you're investing, you have many strategies to consider. But first, you have to decide how much money to put in, what kind of investments to make and when to buy them. One term you might hear when perusing investment types is "dollar-cost averaging," but what does dollar-cost averaging mean? Let's look at what it is and how it works.

Dollar-cost averaging is a strategy of investing a fixed amount of money in a security asset, such as stocks or mutual funds, at fixed intervals. It's used to try to reduce the overall cost of an investment. When you invest in something like stocks, you're essentially buying shares of a company. The price of each share can fluctuate quite a bit. Sometimes the price will go up; other times, it will go down.

By investing a fixed amount of money into the stock regularly—such as weekly or monthly—you can average out the price you ultimately pay for each share. Over time, this can help reduce the overall cost of your investment.

Of course, there's no guarantee the stock price will go up in the long run, but dollar-cost averaging can help to minimize your risk and potentially increase your chances of earning a positive return on your investment.

When it comes to investing, people can employ a variety of strategies to achieve success. The appeal of dollar-cost averaging is that it takes some of the emotion out of investing.

Instead of trying to time the market, investors buy shares at fixed intervals regardless of market conditions. Dollar-cost averaging can also help to reduce the effects of volatility because investors will purchase more shares when prices are low and fewer shares when prices are high.

You may be able to set up an automatic investment plan in which a set amount of money is withdrawn from your bank account automatically to invest in your designated stock or fund. This allows you to steadily build a position in an investment without any extra effort on your part. As a result, this strategy can be an effective way to build a diversified portfolio over time.

Let's say an investor had $6,000 to invest and decided to invest it all at once and they bought when the price was $12 per unit. For their $6,000, they would have purchased 500 units ($6,000/$12)

However, let’s see what could happen if they had invested $1,000 a month over a six-month period during a fluctuating market.

By spreading their $6,000 investment over six months, the average price per unit is reduced to $10.09 and they end up purchasing 600 units. So not only did they end up with more units, they also avoided the stress of trying to guess the best time to invest.

Many people think the best way to make money in the stock market is to buy low and sell high. However, this strategy—known as "buying the dip"—can be challenging if you don't have a lot of knowledge or experience. Even experienced professional investors cannot consistently predict when market dips will occur. And you have to be able to stomach the volatility that can come with market fluctuations.

Dollar-cost averaging isn't necessarily better or worse, but it is a more conservative approach because you're investing a fixed sum of money at regular intervals regardless of the share price. Over time, this can smooth out the ups and downs of the market and reduce your overall risk. While you may not make as much money with dollar-cost averaging as you would with buying the dip, it can be a more reliable and less stressful way to invest.

Research has shown that dollar-cost averaging can underperform lump-sum investing over the long term. While dollar-cost averaging can help reduce volatility in the early years of an investment, it generally leads to lower returns over the long term.

On the other hand, lump-sum investing involves investing all of your capital at once. This can be riskier in the short term and scarier for newer investors, so it often comes down to personal preference.

You're likely already using a dollar-cost averaging technique if you have an employer-sponsored retirement plan, like a 401(k). That's because most 401(k) plans automatically deduct a fixed amount from your paycheck and invest it in a mix of assets, like stocks, bonds and mutual funds each pay period. Investors often use this dollar-cost averaging strategy because it's an easy way to save for retirement without thinking about it too much.

Dollar-cost averaging can be good for beginning investors, especially if they are patient and disciplined. It's a simple investing strategy that can help reduce the risk associated with investing. Over time, dollar-cost averaging can help you create a diversified portfolio. It can make it easier to spread out your investment dollars into multiple types of assets.

One downside, though, is that it may take longer to reach your investment goals. However, it's a solid approach worth trying for people who may be timid about investing or people who may wish to invest a set amount with each paycheck.

The conservative approach that dollar-cost averaging involves can be appealing to those who are retired or near retirement and those who are aiming for a long-term goal:

• People who are retired or close to retirement. Retirees often have more capital than they need to generate income and preserve their principal. As a result, they may want to consider using dollar-cost averaging to protect their nest egg. The benefit of dollar-cost averaging versus investing an entire lump sum is that removes the risk of investing a large sum just before a market decline.

• People who are aiming for a long-term goal. If you're working toward something that's more than five years away, dollar-cost averaging can be a good strategy. This is because you'll likely have time to spread out your purchase price through potential market fluctuation. This helps remove emotion from the picture so you can stay invested and on track to meet your longer term investment objectives.

Dollar-cost averaging isn't suitable for everyone. In cases such as these, other strategies may be more advantageous:

• You're trying to time the market. One of the main benefits of dollar-cost averaging is that there isn't much market guesswork to do. It's a conservative and steady method that doesn't involve you actively buying and selling.

• You need immediate income from your investments. Another benefit of dollar-cost averaging is that it can help preserve your capital over time. So this may not be the best approach if you're looking for quick investment income.

• You don't have the discipline or the resources to stick with it. Dollar-cost averaging requires patience. If you don't think you can commit to investing at regular intervals or have inconsistent income, this strategy probably isn't right for you.

Ultimately, dollar-cost averaging can be a great way to reduce your overall risk and build your portfolio over time. But you should consider your individual circumstances before deciding if this strategy is right for you.

Always remember that dollar-cost averaging does not guarantee profits. In fact, you could lose money if the security you're investing in declines in value. While many people might expect that the value of the shares purchased will always eventually end up higher than their original cost, this is not always the case.

Dollar-cost averaging also can take a long time to generate profits. If you're hoping for a quick return on your investment, this may not be the best option for you.

Also be aware that transaction costs like commissions and fees can negatively affect your overall return.

Ultimately, when done correctly by a disciplined, patient investor, dollar-cost averaging can be an effective way to manage your investments. Contact a financial advisor to unlock the full potential of your investments.