Dollar cost averaging is a tactic that can lower your investing costs and reduce risk at the same time. Dollar cost averaging can help you cut your investing costs and increase profits over the long term.
To dollar-cost-average, you invest the same amount of money at regular periods in a certain asset. Instead of trying to time the market, you purchase at a variety of prices. Dollar-cost averaging isn't for everyone, and there are situations when it works better than alternative investing techniques.
In removing some of the emotional barriers to investing, however, it can be an effective tool. In this post, you’ll learn how dollar-cost averaging works and when it's the most effective for saving money along with its potential downsides.
What Exactly is Dollar Cost Averaging?
With investments like stocks and mutual funds, there is the chance of losing money if you don't control the price risk. Dollar-cost averaging is a strategy for diversifying your investment portfolio by purchasing modest amounts of an asset at regular intervals rather than investing in a single item at a fixed price.
This reduces the danger of overpaying for investment before the market has a chance to correct itself. Of course, prices don't just go up or down. You may, however, get a better deal if you spread out your purchase over a longer period of time. If you want to build wealth over the long run, dollar cost averaging helps you get your money to work consistently.
Market Timing vs. Dollar Cost Averaging
Because asset values grow over the long run, dollar-cost averaging is effective. However, asset values are not expected to grow steadily in the foreseeable future. As a substitute, they chase short-term peaks and troughs that may or may not follow a pattern.
Attempts have been made by many to time the market and acquire assets at cheap prices. In principle, this should be straightforward. Even for skilled stock pickers, predicting the market's short-term movement is almost impossible in reality. This week's low might be next week's high price. A month from now, the recent high may seem to be a bargain.
In hindsight, you can only determine what a fair price for a particular item would have been—and by then, the opportunity to acquire has passed. Waiting on the sidelines and trying to time your asset acquisition often results in you purchasing at a price that has already plateaued.
Who Can Benefit from Dollar-Cost Averaging?
Dollar-cost averaging makes it easier to start investing with tiny sums of money. For example, you may not have a huge amount of money to invest at once. Smaller sums of money are put into the market on a regular basis via dollar-cost averaging. There is no need to wait until you've accumulated a huge sum to reap the benefits of market expansion.
When the market is down, dollar cost averaging's monthly investments guarantee that you're still investing. Maintaining assets amid market downturns may be a daunting task for some individuals. It's possible to lose out on future growth by not continuing to invest or withdrawing your current assets during a down market.
People who keep their money in the market during bear markets have traditionally experienced greater returns than those who withdraw their money and then attempt to time a market recovery, according to Charles Schwab data.
The Downsides of Dollar-Cost Averaging
Dollar-cost averaging has its own set of considerations. There are a number of reasons why it's hard to anticipate stock values on any given day, week, or year. Markets do grow over time, as shown by more than a century of data.
You may prevent short-term market volatility by keeping the majority of your assets out of the market and only adding to them gradually. But it also means that some of your money is sitting on the sidelines and not doing anything for your financial well-being.
The danger is much greater if you're looking for dividend-paying stocks and other income-producing assets. The majority of dividend payers continue to distribute in both good and poor economic times. You won't get dividends on the money you haven't yet invested if you utilize dollar-cost averaging to develop a stake in a dividend company.
Finally, keep in mind that any investment plan is only as good as the stocks that you choose to buy and sell. As a general rule, dollar-cost averaging may help alleviate investor anxiety, but it's not a replacement for identifying high-quality businesses to invest in.
Final Thoughts
Keep yourself invested in the market even when the market is down by using dollar-cost averaging as an investing technique. You may better position yourself and your assets for long-term success by using dollar-cost averaging, which removes emotion from purchase choices, particularly in down markets.