There are a number of investment strategies for those looking to generate value from their money, among them dollar-cost averaging. Dollar-cost averaging can be an effective way to ensure regular investments over time, by slowly but surely building up your portfolio and increasing your wealth.
What is Dollar-Cost Averaging?
Dollar-cost averaging is the idea that you will invest a consistent sum of money on a regular basis, regardless of market volatility or share price.
In other words, no matter whether the market is up or down, you will invest the same amount of money at your chosen intervals. These can be bi-monthly, monthly, or quarterly, depending on your financial situation and your preferences.
As such, dollar-cost averaging is a strategy that seeks to “average” out the purchase price you pay for assets over time, hence the name.
The following example can illustrate how this works in practice. Jill decides to invest $100 every month to purchase a specific index fund. If the price is $5 per share, she will acquire 20 shares ($5 x 20 = $100). However, if the price jumps to $10 a share, she will be able to purchase 10 shares ($10 x 10 = $100). Jill is not purchasing a particular amount of shares each month, rather she is investing a specific amount of money ($100).
What is the Best Way to Implement a Dollar-Cost Averaging Strategy?
As with any investment strategy, how you implement a dollar-cost averaging strategy should depend on your particular financial situation and objectives.
First, start with the amount of monies you can comfortably invest and decide upon your desired timeframes. If you are unsure, creating a monthly budget can help you understand how much money you have at your disposal. You can start small and always ramp up your investments if your situation changes and you can devote additional funds to your investments.
Second, decide on an investment strategy that fits your risk profile and preferred activity. For most individuals, an Exchange Traded Fund that tracks an index could make a lot of sense, as it spreads both risk and reward among a variety of underlying assets. Alternately, if there is a particular publicly traded company that you are bullish about, you can also make plans to regularly purchase this stock, acquiring more and more shares as the months go by.
What are the Benefits of Dollar-Cost Averaging?
There are number of benefits from dollar-cost averaging, which can be broken down into two main categories of advantages.
The first advantage of this strategy is that it will automatically force you to devote money towards building your investment portfolio at regular intervals. Dollar-cost averaging guarantees that a portion of your regular income will be dedicated to an active investment, as opposed to being used for consumption or passively sitting in your low-interest savings or checking account.
The second benefit is that you will avoid the danger of pouring your monies into the market at inopportune times. Though historically the stock market has generated wealth in the aggregate, investing in the stock market is not without risk. There are certain periods when the market will drop (sometimes precipitously), and if you invest all of your monies just before one of these slides you will lose enormous value.
Dollar-cost averaging addresses this risk: you will buy at times that are optimal and you will buy at times that are not. No matter what, you will continue to buy, and on average your gains will cancel out your losses. Over time, as the market climbs upwards, your growing portfolio will continue to expand and gain value.
Are There Drawbacks to Dollar-Cost Averaging?
Every investment strategy has certain drawbacks, and dollar-cost averaging is no exception. Just as dollar-cost averaging will prevent you from experiencing big losses, you are also unlikely to enjoy sudden windfalls.
Consider the earlier example of Jill. Suppose that, in addition to her regular monthly investments of $100, she receives a one-time gift of $10,000. She decides to place the entire gift in the market, adding to her regular, dollar-cost averaging, monthly investment. Jill uses the entirety of this sum to purchase shares at a price of $5 per share.
Luckily for her, in the next quarter, the ETF doubles in value and she enjoys a marked increase in her wealth. Had she stuck with the dollar-cost average approach, Jill’s portfolio would have grown, but she would have missed out on these more significant gains.
The opposite could also have occurred had the market tanked, of course, causing Jill to suffer severe losses. Dollar-cost averaging avoids both of these scenarios, making it an attractive option for those with less adventurous risk tolerance.
Conclusion: Dollar-Cost Averaging for the Average Investor
Dollar-cost averaging is a system that encourages the regular contribution of funds into your investments. It is a straightforward way to guarantee the continued flow of monies into your investments, while avoiding the pitfalls of losing massive amounts of capital that can occur if your invest at the wrong time.
It is also a simple strategy for beginners to follow. It removes a significant portion of the risk, though finding strong assets to invest in remains a crucial part of this strategy. For this reason, an index fund is a good place for inexperienced investors to start.
As with all types of investments, starting early and remaining committed can help you to create value over time. This is due to the fact that you will be adding monies regularly, but also due to the magic of compound interest, whereby your investment earnings will start to generate their own wealth. Using TipRanks’ compound interest calculator can help you understand how this works in practice.
Whatever your investment horizon, it is advantageous to regularly contribute whatever monies you can to expanding your portfolio. Dollar-cost averaging is one strategy to make this happen.
Learn money management, and use data-driven stock insights with TipRanks.
