Are you consistently investing each month? If not, dollar-cost averaging is a technique that can help make your investing activities more consistent and productive. Dollar-cost averaging is the investment strategy of investing a fixed amount of money each month. You probably already follow this strategy with your 401(k), even if you don’t realize it!
It’s surprising how much money ends up in your 401(k) if you stick with it long enough. You don’t miss the money, because it never hits your bank account, where it can tempt you to spend it on something else.
You can take advantage of the same strategy to invest money outside of your employer-sponsored retirement accounts.
Dollar-cost averaging has many advantages:
- You can begin investing with a small amount of money. An index fund or other type of mutual fund is ideal for this strategy. It’s not necessary to begin with a large lump sum. Your current financial situation is a good starting point for this strategy.
- You’re consistently saving and investing. Your brokerage service can automatically deduct money from your account each month and invest those funds per your instructions. You’ll be saving and investing automatically.
- You’ll learn to live on less. Spending has a way of expanding to fill the month. If you currently follow the strategy of saving whatever money is left over at the end of each month, you’re probably not saving much. By having the money removed from your immediate access, it’s far more challenging to spend it on something else.
- You hedge your risk against market fluctuations. No one has consistently shown an ability to time the market effectively. The most productive strategy over the long-term is to invest consistently.
- Investing a large lump sum at one time has been shown to be risky. How can you know what the market will do over the next month? The market may be at a high point and fall considerably over the next few weeks. Studies have shown that breaking up a large investment over many months, or even years, is a more effective strategy.
- By investing consistently, you’ll have the opportunity to purchase more shares when the market hits low points.
- Consider the following table:
Date Investment Price per Share Shares Purchased
- More shares are purchased when the price is lower. A higher stock or mutual fund price results in fewer shares purchased. The net result is a lower average cost per share over time.
- Notice that if the full $3,000 had been invested in the first month, the total number of shares acquired would be less – 60 versus 62.1.
- While it’s possible that you might make a large investment at the opportune time, several studies have shown an advantage of roughly 5% for breaking up large investments over long periods of time.
- Your average share price is likely to be less if you invest consistently rather than make larger, less frequent investments.
With dollar-cost averaging, you build your portfolio over time and reduce your market risk. All of this happens regardless of market conditions. There’s no longer a reason to concern yourself with economic conditions until you near retirement. As you approach retirement age, market conditions become more of a concern, but that’s true of all investment strategies.
It’s a wonderful strategy for the average investor that has a long-term horizon and lacks the interest or time to research investments seriously.
Keep these other factors in mind before adopting a dollar-cost averaging strategy:
- Keep an eye on the fees. Mutual funds are notorious for charging a variety of fees:
- Exchange fees
- Low-balance fees
- Front loads
- Purchase fees
- And the list goes on.
- It’s imperative to avoid funds with flag-drop fees – those fees that are charged on each transaction. Stick with funds that have lower fees, and your returns will be higher in the long run. Managed funds haven’t been shown to do better than those that invest by a formula, such as index funds.
- Be consistent. It’s not an effective strategy if you’re unable to follow it consistently. Ideally, you’d be investing at least once each month. More frequently would be even more effective.
- Remember that good and bad markets can last for years. Maintain the strategy regardless of market conditions. The market has always turned around. Take advantage of those times the market is languishing. You can lay the foundation for a significant, future gain.
- It may be the only way the average person can invest. There are a few experts that disagree with dollar-cost averaging as an investment strategy. However, few people have large sums of money to invest at one time. Human psychology being what it is, it’s also much more stressful to invest a large sum of money at once.
- Dollar-cost averaging is the easiest way for the average person to save and invest money on a consistent basis. Stick with a strategy you can maintain.
Many mutual funds have automatic investment plans. Inquire today if your current funds have such an option. A quick search online will result in numerous options.
Dollar cost-averaging provides a clear and productive path for the average investor. It may not be the most sophisticated investing strategy, but it has been shown to be one of the most effective. Consistently saving and investing will always be a successful strategy.
The real challenge for most of us is saving in the first place. Take the first step today. You’ll be grateful in the future.