Dollar-cost averaging is a passive investing strategy widely used by investors. It is the process of purchasing a fixed dollar amount of a particular investment on a schedule, regardless of the price. This means the number of shares you purchase will fluctuate depending on the market price.
If you are investing in a 401K or IRA there is a good chance you are utilizing dollar-cost averaging and contributing a set amount each month without really assessing your investment.
As an example, let say you want to use dollar-cost averaging to buy shares of Disney. You first decide how often you want to invest, let’s say once per month. You then decide the amount of money you want to invest each time, let’s say $500. As of writing this post, Disney trades at $110/share. This means you could purchase 4 shares of Disney. Let’s say next month Disney goes down to $90/share. This means you can now purchase 5 shares of Disney. You get the idea, it’s a fairly simple concept.
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What are the benefits of dollar-cost averaging?
Timing: Accurately and consistently timing the market is near impossible. Many folks will try to time the market and most will fail. By utilizing dollar-cost averaging you just invest money monthly and don’t worry a bit about timing. That said, you don’t have to time the market 100% accurately to make a decent return. If you are investing for the long haul (I’m talking years), regardless of whether you use dollar-cost averaging or not, timing is not as big of an issue anyways.
Determining A Fair Market Price: One of the more tedious parts of stock investing is determining if the market price of a stock is a reasonable valuation. By using dollar-cost averaging you essentially ignore the price per share and just buy how ever many shares you can with the amount of money you are investing. This does not mean you should practice dollar-cost averaging with just any stock. After all, if you practice dollar-cost averaging with a terrible company you are bound to lose money in the end.
Affordable Diversity: Most people don’t have enough money to create a diverse portfolio. By using dollar cost averaging in the form of an index fund, you can get a well diversified portfolio without having to contribute much money each month.
Removes Emotions: Emotions are not usually a good thing when it comes to investing. As humans, it’s tough to not let emotions get in the way of your investing. It’s easy to get scared and sell when your stock drops 10% after a bad earnings call. Fortunately, dollar-cost averaging takes the emotional aspect out of investing. You just invest a set amount of money and forget about it.
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What are the drawbacks of dollar-cost averaging?
More Fees: Depending on your brokerage, by using dollar-cost averaging (as opposed to investing a lump sum) you will likely rack up more transaction fees that will ultimately take away from your return. For this reason, dollar cost averaging makes more sense when you are investing in a 401K, IRA, or a similar fund that allows you to contribute money each month without paying a fee for every single transaction.
Over-Paying: By completely ignoring the market price of a stock via dollar-cost averaging, you run the risk of paying too much for a stock. This is especially true with some of the tech stocks that have big swings and trade at sometimes crazy valuations. This could ultimately negatively impact your return.
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A Final Note
As a final note, dollar-cost averaging can be a great strategy for the inexperienced and experienced investor alike. Although dollar-cost averaging takes away a lot of the risks and human errors associated with investing, you should still thoroughly research each investment you make before sinking your hard earned money into it.