Most people want to invest while prices are low and sell when prices are high, with the goal of making a profit. But it’s impossible to accurately predict the stock market’s ups and downs. That’s why many investors use dollar-cost averaging, which allows you to invest at all levels of the market and hedge your investment risk over time.
Dollar-cost averaging is an investment strategy in which you invest a fixed dollar amount at regular intervals, regardless of the price.
That means when the share price is high, you’re purchasing fewer shares, and when the share price is lower, you’re purchasing more shares. Over time, your regular investments will allow you to make purchases at both market highs and lows, mitigating your overall risk.
With dollar-cost averaging, you invest the same amount of money at regular intervals, such as weekly or monthly.
For example, say you want to invest $5,000 in a particular company’s stock. Rather than making a lump sum investment of $5,000, with dollar-cost averaging, you might instead invest $1,000 each month for five months. Dollar-cost averaging works by spreading out your investment over a period of time.
Here's how it works: imagine that over those five months, the company’s stock price fluctuated from $50 to $40, $30, $20, and $50. In the first month, your $1,000 would have purchased 20 shares, but in the fourth month, the same investment would have purchased 50 shares.
Through dollar-cost averaging, you were able to buy more shares than if you had made the entire $5,000 investment all at once (a "lump-sum investment"). As a result, you own more shares when the stock price begins rising again, and have the potential to earn greater returns.
Of course, there are times when the stock price will go straight up for five months in a row, in which case it would have been more beneficial to invest a lump sum during the first month. But nobody can precisely time the market. And because investing in the market comes with ups and downs, dollar-cost averaging is a smart way to lower your risk and maximize the potential.
Dollar-cost averaging isn’t a perfect strategy (because there is no perfect investing strategy), but it offers a number of benefits, such as:
It’s natural to react emotionally to the stock market’s ups and downs, rushing to sell when stocks go down, and rushing to buy when the market appears to be rising. These kinds of attempts to "time the market" are notoriously unsuccessful. That’s where dollar-cost averaging comes in. It takes the emotion out of investing, so you’re focused on investing a fixed amount on a specific schedule, rather than on the market’s fluctuations. As a result, you’re more likely to avoid the temptation to try to time the market.
With dollar-cost averaging, you're able to purchase more shares of an investment when the price is low and fewer shares when the price is high. Over time, this can mean you pay a lower average price per share, depending on when you're active in the market.
Rather than investing all your money at the same time, dollar-cost averaging allows you to invest a set amount over time, so that if the market declines, your risk of losses may be lower.
If you have a large sum of money available to invest, it can be difficult to decide whether to make a lump-sum investment or invest with dollar-cost averaging. The right decision depends on your risk tolerance and your investment horizon.
For example, a lump-sum investment often results in higher gains over the short term. If you invest a lump sum during a bear market, your investment may immediately begin earning high returns (or ROI) when the market reverses. However, there’s no way to time the market. If you invest a large sum just before the market drops, you may experience significant losses before you start earning gains. For that reason, you should have an appetite for risk if you plan to make a lump-sum investment.
Dollar-cost averaging, on the other hand, may lessen your timing risk because you’re not putting all your funds in the market at once. However, dollar-cost averaging requires discipline. It’s important to stick to your plan, even if the market is dropping, because the consistent commitment to investing a set amount is what makes dollar-cost averaging work for long-term investing.
Lump-sum investing can earn faster and bigger returns, depending on the current market, but that doesn’t mean it’s superior to dollar-cost averaging. If you can tolerate the risk, lump sum investing may be the right choice when you have a windfall of cash.
But there’s no substitute for dollar-cost averaging in long-term investing, such as building a retirement fund. When you allocate a portion of each paycheck to a 401(k) or other retirement account, you’re taking advantage of dollar-cost averaging and investing in the market’s ups and downs over time. That steady, committed approach to investing can help you build a secure financial future over the long term.
The basic rules for dollar-cost averaging are to commit to investing a set amount of money at specific intervals, and to stick to your plan. You can do this in a variety of ways.
One of the most common is through regular payroll contributions to your retirement account. For example, you might commit to contributing 10% of each paycheck to a retirement account. You can work with your employer to set up such contributions to your employer-sponsored retirement plan or an individual retirement account (IRA).
You can also participate in dollar-cost averaging through your own brokerage account. For example, an Acorns Invest accounts allow you to set up daily, weekly or monthly contributions starting at $5 and round up your spare change to consistently invest. Through regular, ongoing investments, you can use the dollar-cost averaging strategy and benefit from participating in the stock market over time.
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