Dollar-cost averaging is a disciplined way for investors to build wealth in their portfolio over time while helping them avoid emotional-driven decisions.
Many people mistakenly believe that they need thousands of dollars to start investing for their retirement, causing them to be risk-adverse in opening a traditional investment retirement account or Roth IRA. But nearly anyone can get started with the strategy. For instance, this style of investing can help novice investors who have recently opened a retirement portfolio, and don’t have a large sum of money for an initial investment.
Here are answers to a few common questions about dollar-cost averaging:
— What is dollar-cost averaging?
— How does dollar-cost averaging help you?
— How do you calculate a dollar-cost averaging example?
— What are some of the advantages of dollar-cost averaging?
What Is Dollar-Cost Averaging?
Dollar-cost averaging is a simple investment strategy that calls for investing the same amount of money on a consistent basis, says Greg McBride, chief financial analyst at Bankrate.com, a New York-based financial data and content company.
One of the benefits is buying more shares when prices are low and fewer shares when prices are high over a period of time, he says.
[See: 10 Long-Term Investing Strategies That Work.]
Another advantage of this strategy is a small amount of money can be invested until income levels increase, or until a novice investor can understand more complex investments, such as exchange-traded funds, which typically focus on a specific sector.
Investors who follow this strategy will invest either once or twice a month into a particular investment, such as mutual funds or ETFs.
The best way to build long-term wealth is to simply buy shares in a broadly diversified income fund on a regular basis whether the market has recently gone up, down or sideways, financial advisors say.
How Does Dollar-Cost Averaging Help You?
One of the advantages of this technique is it allows people, particularly novice investors, to start investing with relatively small amounts of money. When a fixed amount of money, such as $300, is invested every month into a fund, such as a mutual fund or ETF, or an account like a 401(k) or a Roth IRA, that’s dollar-cost averaging. This is a better strategy than investing a lump sum of money whenever you think the market conditions are good.
Dollar-cost averaging allows investors to put their investment strategy on autopilot, experts say.
How Do You Calculate a Dollar-Cost Averaging Example?
As an example, investors can sock away $300 into a mutual fund at $20 a share and add 15 shares to their portfolio.
With dollar-cost averaging, investors can set aside $100 per month, and during the first month it’s invested, they will net five shares if the price is $20 per share, McBride says.
[Read: These Mistakes Can Blow an Index Investing Strategy.]
In the second month, if the price has fallen to $10, they now acquire 10 shares. By the third month, if the price has climbed to $25, then a $100 investment buys four shares. An investor now has a total of 19 shares at an average cost of $15.79 per share instead of 15 shares at an average cost of $20 per share.
Investors can also use online dollar-cost averaging calculators, which can be found on many personal finance and investment websites. These calculators allow an investor to put in the different share prices of a stock and determine what the dollar-cost average would be over time.
What Are Some of the Advantages of Dollar-Cost Averaging?
The opportunity to buy stocks when prices are lower is one advantage of this method.
“Dollar-cost averaging does not guarantee a profit or guarantee that the strategy is better than buying in a lump sum,” he says. “But it enforces a discipline of buying more when prices are low and buying less when prices are high. Left to their own devices, investors too often buy high, but sell low. Dollar-cost averaging helps take the emotion out of investing.”
This strategy is a useful technique to purchase individual stocks if it is applied correctly, says Ron McCoy, CEO of Freedom Capital Advisors in Clermont, Florida. This strategy requires planning before any positions are initiated, since position sizing comes into play.
If there is a particular company of interest and an investor wants to purchase shares, experts recommend initiating a small position to begin with to give the stock several weeks or months to play out. For instance, investors can allocate one-third or a quarter of the money toward the total amount of what they ultimately want to own, “especially in a down market where the stock appears to be cheap, but is trending lower,” McCoy says.
[Read: Why Value Investing is Making a Comeback.]
An investor who chooses to use dollar-cost averaging should ensure that subsequent purchases lower the cost significantly.
“Buying 100 shares at $20 and then buying another 100 at $18 may not make sense, since it only lowers your cost from $20 to $19,” McCoy says. “However, adding 100 shares at $14 would lower your cost to $17. You can always add to your position if the trend changes and moves higher. In order for the strategy to work, you must have strong conviction and knowledge of the company you are buying.”
This strategy is a mechanical approach to investing, says C.J. Brott, founder of Capital Ideas, a registered investment advisor in Dallas.
“By keeping the dollar amount of your purchases constant, you will always buy more shares at a lower price and fewer at a higher price,” he says. “The average cost per unit is lower than the average price.”
Investors are often concerned that prices will decline or that they are not purchasing an ETF or stock at a low price.
“This strategy is very important because it forces you to buy more when prices are low, overcoming fear,” he says. “It also keeps you from hocking the house to buy large amounts on price highs, thus overcoming greed. Both actions go totally against human nature and provide that level of boredom that usually accompanies successful investing strategies.”
The key to successful long-term investing is overcoming emotions, such as fear or greed.
“It is more difficult than most understand to know yourself and anticipate how you will react given certain market conditions,” Brott says.
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What Is Dollar-Cost Averaging? originally appeared on usnews.com
