A simple strategy that entails investing a specific sum of money over time in the same fund or business is dollar-cost averaging.
 |
| Dollar-Cost Averaging Can Help You Build Wealth Over Time |
Make no mistake: dollar-cost averaging is a technique that may provide profits comparable to or better than buying low and selling high. Nobody can time the market, as many experts would tell you.
- In order to use dollar-cost averaging, an investor must continuously make the same investment in the same stock over time, regardless of the share price.
- Compared to trying to time the market, this approach yields results that are on par with or better over time.
- Dollar-cost averaging is a particularly alluring approach for inexperienced investors with modest capital. They might make modest initial investments and eventually reap favorable returns.
Utilizing Dollar-Cost Averaging for Investing
There is nothing more simple in the strategy. Invest the same sum of money each month in the same mutual fund or stock. If the price of your investment changes, ignore it. Regardless of whether it rises or falls, you are investing the same amount of money.
- Dividend payments can even be automatically reinvested in the shares to achieve this.
Depending on the share price of the investment at the time of acquisition, the number of shares purchased each month will change. Your investment will purchase fewer shares per dollar when the stock's value rises. You can purchase more shares with your money when the stock price drops.
Your average cost per share over time should be fairly close to what you would have paid if you had tried timing it.
Consider investing in an exchange-traded fund or a no-load mutual fund utilizing the dollar-cost averaging approach. This might provide you with the benefit of diversification.
Dollar-Cost Averaging's Advantages
This is a really wise investment plan in the long run. Your average cost per share decreases over time as a result of purchasing more shares when the price is low.
For new and inexperienced investors, dollar-cost averaging is highly alluring. It's a method for building money gradually but steadily, even if you only make a small initial investment.
Example of Dollar-Cost Averaging
- Consider a scenario where an investor puts $1,000 into Mutual Fund XYZ on the first of every month starting in January. The price of this fund, like any other investment, changes every month.
- In January, shares of Mutual Fund XYZ were trading at $20 each. From February 1st to March 1st, it was $16, $17 on April 1st, $23 on May 1st, and $12 on March 1st.
On the first of every month, the investor still deposits $1,000 into the fund, even though the quantity of shares bought varies. In January, 50 shares were bought for $1,000. In February, 83.3 shares were bought, followed by 58.2 shares in April, 43.48 shares in May, and 62.5 shares in February.
Five months after beginning to make contributions, the investor now owns 298.14 shares of the mutual fund. Investing $5,000 has increased to $6,857.11. These shares typically trade for $16.77. By today's share price, the $5,000 investment has increased to $6,857.11.
The investor might have made more or less money overall if they had spent the entire $5,000 at any point during this time frame. But by spreading out the purchases, the risk of the investment has been significantly reduced. Using dollar-cost averaging to get a good share price is less dangerous.
Why Make Use of Mutual Funds?
When using the dollar-cost averaging technique, there might not be a better investment vehicle than a no-load mutual fund. These mutual funds could have been designed with dollar-cost averaging in mind, as they allow for commission-free purchases and sales.
As an expense ratio, mutual fund participants pay a fixed percentage of their total contribution. Compared to a $250 or $2,500 lump-sum investment, that percentage deducts the same proportionate amount from a $25 investment or recurring payment amount.
For instance, you would pay a fee of $0.05, or 0.2 percent, if you made a $25 installment payment in a mutual fund with a 20 basis-point cost ratio. In the same fund, a $250 lump-sum investment would cost you $0.50, or 0.2 percent.
A Range of Funds for Average Dollar-Cost
However, the availability of no-load mutual funds—which by definition do not impose transaction fees—as well as their low minimum investment requirements enable almost anyone to invest. Several mutual funds do, in fact, waive minimum requirements for participants who set up dollar-cost averaging automatic contribution plans.
To significantly cut expenses, think about index funds or exchange-traded funds (ETFs). The performance of a particular index is tracked by these funds, which are not actively managed. Since there are no management fees, the costs are a very small percentage.
A Prolonged Strategy
It is a long-term strategy, regardless of the amount of money you have to invest.
Even though the financial markets are constantly shifting, most stocks have a tendency to follow broad trends for extended periods of time, driven by broader economic trends.
For months or even years, a market may be in a bull or bear market. Because of this, dollar-cost averaging is less useful as a short-term strategy.
Moreover, the value of mutual funds and even individual stocks does not, on average, fluctuate much from month to month. The real benefit of dollar-cost averaging requires that you maintain your investment through both prosperous and unsuccessful periods. Both the premiums of a bull market and the discounts of a down market will eventually be reflected in your assets.
