Buying more shares when prices are low is the recipe for long-term investment success, and dollar-cost averaging accomplishes that without the guesswork involved in timing the market.
When it comes to investing strategies, it seems as though everyone from the multibillion-dollar portfolio manager to the local mechanic has a theory. Passive or active management, buy and hold, technical or fundamental analysis and value investing are but a few examples. But dollar-cost averaging is a long-term strategy particularly suited for individual investors — at least those who don’t have $250,000, $500,000 or even millions of dollars on hand to meet private wealth management minimums.
- How Dollar-Cost Averaging Works
- The Benefits of Dollar-Cost Averaging
- Does Dollar-Cost Averaging Increase Returns?
- Is Dollar-Cost Averaging Better Than Lump Sum?
- Myths Related to Dollar-Cost Averaging
- Dollar-Cost Averaging Example
- Does Dollar-Cost Averaging Really Work?
Dollar-cost averaging involves investing your money in a fixed dollar amount on a predetermined basis, such as monthly or quarterly, regardless of market conditions. The result of this approach is that the fixed dollar amount buys more shares when the price falls and less as it rises. As a result, your overall investment strategy is less vulnerable to a market crash because it keeps some of your money out of the market for some time, thereby reducing your risk.
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One of the basic principles of dollar-cost averaging is to remove the concept of market timing from the equation. As dollar-cost averaging proponents are keen to point out, investment novices and professionals alike have been burned numerous times trying to get in and out of the market at just the right time.
The impact of missing just a few key days in the market can be significant. For example, if you had missed the 90 best performing days in the stock market from 1963 to 2004, your average return would have dropped from around 11% to just over 3%. That’s just 90 days out of about 10,000 trading days.
Perhaps as important as taking the guesswork out of the investing process, dollar-cost averaging is also a means of implementing an ongoing, consistent savings regimen — a good idea regardless of market conditions. In fact, many people already employ dollar-cost averaging in their retirement planning strategy, though they may not realize it, in the form of monthly contributions to a 401(k) or other qualified retirement plan.
Although dollar-cost averaging just might increase your returns, it’s important to keep in mind that reduced-risk investments typically provide lower returns. But dollar-cost averaging removes the pressure of selling and buying when the market is high or low, and when you invest the same amount each month you automatically buy more shares when the market is down and fewer when it’s up.
Making a decision on how to invest your money is not an easy one. You can invest a lump sum in the market and see what the market returns, you can wait for the market to go down and buy in low or you can dollar-cost average and reduce your risk.
Vanguard research showed that investors typically do best by investing a lump sum, due to the fact that the market generally rises three out of four years. The study compared a lump-sum investment over a year with a dollar-cost average investment that involved 12 monthly purchases over the course of a year. Vanguard found that approximately 64% of the time the lump sum strategy made an average of 1.5% to 2.4% more than the dollar-cost-averaging approach.
That said, dollar-cost averaging might be for you if you want to do the following:
- Decrease the risk of a huge investment
- Lower the average price you pay per share to take advantage of the market’s inherent volatility
- Avoid misgivings if the market goes down — you signed up for the long haul
There’s no avoiding the fact that investing entails assuming some measure of risk. Minimizing that risk is one of the key components of a dollar-cost averaging investment approach, though that is all it does — minimize risk.
Yes, dollar-cost averaging ensures more shares are purchased when prices fall, but it does not address the strength of the underlying security. This is part of the reason many small investors opt for dollar-cost averaging using mutual funds to further minimize portfolio risk.
This example illustrates how dollar-cost averaging is implemented and the impact it can have over time.
|Dollar-Cost Averaging Example|
|Monthly Investment||Share Price||Number of Shares|
Whereas the numbers might be small, this example illustrates the value of dollar-cost averaging. Instead of investing $1,200 in month 1 and receiving 120 shares in return, dollar-cost averaging results in an additional 6.45 shares because as the price drops, the same $100 buys more shares. In this instance, were the shares simply to return to their initial offering price of $10, this investor would see a positive gain.
The key to dollar-cost averaging success is to maintain it regardless of what the market did or didn’t do on a particular day. In fact, the occasional share price drop will work to the benefit of the dollar-cost averaging investor.
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Tim Brugger contributed to the reporting for this article.