What Is Dollar-Cost Averaging?
A strategy known as dollar-cost averaging can assist you in lowering the total amount you pay for investments and reducing the associated risk level. Utilizing this strategy can help bring down the overall cost of your assets over a significantly more extended period of time.
Dollar-cost averaging is most effective for individual investors who do not spread the cost of a position in a stock, commodity or such asset over a range of its values throughout the investor’s investment period, as well as for passive investors who invest for the long term.
Reducing price risk
When exchange-traded funds (ETFs) or mutual funds (MFs) buy stocks, they tend to adopt dollar-cost averaging in order to reduce the price risk.
If you have a workplace retirement plan, you probably already use dollar-cost averaging for at least some of your investing.
How dollar-cost averaging works
Dollar-cost averaging is a simple way for investors to save money and build wealth over time. It's also a way for investors to ignore short-term market changes.
Long-term dollar-cost averaging is most often used in 401(k) plans, where employees make regular investments no matter the investment price.
With a 401(k) plan, employees can choose the amount they would like to invest, and the investments they would like to make. Then, every time the employee gets paid, investments will be created automatically. An employee's account could get more or fewer securities depending on how the markets are performing.
Dollar-cost averaging investment can also be used outside of 401(k) plans. For example, investors can use it to buy mutual funds or index funds regularly, either in a tax-advantaged account like a traditional IRA or in a taxable brokerage account.
One of the best ways for new investors to trade in ETFs is with dollar-cost averaging. Also, many dividend reinvestment plans let investors take advantage of dollar-cost averaging by making regular purchases.
Examples of dollar-cost averaging
Here is an example of dollar-cost averaging in a market that fluctuates little. Assume that over a year, you spend $10,000 on four separate transactions at $50, $40, $60, and $55. That's equivalent to buying 199.6 shares simultaneously, spread across four separate purchases. Therefore, the expected value is very similar to the previous case, suggesting that the outcome won't change your life significantly one way or the other.
Despite its superficial similarity to the lump sum buy, this strategy reduces your chances of market timing errors, while incurring fewer costs overall. For extended periods, markets and equities may trend sideways, going up and down but returning to their original levels. On the other hand, you can never be sure of the direction the markets will go.
One might have made an even more significant return by dollar-cost averaging if the stock had fallen rather than risen. Buying on price declines is crucial for maximizing long-term returns.
Benefits of dollar-cost averaging
• Lessens irrational behaviour caused by investing decisions based on emotions, like when investors try to time the market and make bad choices.
• Lessens the risk of making significant stock investments because the spread-out plan lets you buy the asset at different prices that may be better in the long run.
It's a convenient investment method that can be set up automatically with stock brokers like Vanguard, Schwab, and others. It encourages investment discipline and routine.
It is also an inexpensive method of investing because you can invest small amounts of money regularly instead of saving up a lot of money to invest.
Your money will still grow if you use dollar-cost averaging. Research by the Financial Planning Association and Vanguard have shown that investors who used dollar-cost averaging saw their investments grow. But most of the time, it was just a little less than if it had been invested in lump sum.
Q. Is it wise to use dollar-cost averaging?
It could be. When you use dollar-cost averaging, you invest the same amount at regular intervals. Doing this can lower the average price of what you buy. You will already be in the market when prices go up or down. For instance, you won't have to try time dips because you'll be exposed to them when they happen. Investing a fixed amount every month will buy more shares when the price is low than when it is high.
Q. Why do some investors use dollar-cost averaging?
The main benefit of dollar-cost averaging is that it makes a portfolio less vulnerable to the harmful effects of investor psychology and market timing. By committing to dollar-cost averaging, investors reduce the chance of making wrong decisions out of greed or fear, like buying more when prices go up or selling in a panic when prices go down.
Instead, dollar-cost averaging makes investors focus on spending a set amount of money each time, regardless of the cost of the target security.
Q. How often should you invest using dollar-cost averaging?
How often you use the strategy may depend on how long you plan to invest, how you see the market, and how much you know about investing. If you think the market will change and go up in the long run, you might try it. If there is a persistent bear market, it isn't a good idea to use this strategy. If you want to use it as a long-term investment and need to figure out how often to buy, you could put some of each paycheck toward the purchases.
Equity risk premium (ERP) is the difference between the expected return on equity and the risk-free rate. The ERP is often used as a tool to measure the relative attractiveness of investing in stocks.