Dollar cost averaging is one of the easiest techniques to increase your profits without taking on additional risk, and is a great way to practice buy-and-hold investing. Dollar cost averaging is even better for people who want to settle their investments and deal with them infrequently. is one of the most powerful and easiest investment strategies and is great for individual investors.
Here’s what dollar cost averaging is and how to use it to maximize returns on your investment.
Reading: Investing weekly vs monthly
what is the average cost in dollars?
Dollar cost averaging is the practice of putting a fixed amount of money into an investment on a regular basis, usually monthly or even bi-weekly. If you have a 401(k) retirement account, you’re already doing dollar cost averaging by increasing your investments with each paycheck.
By doing this over time, you are spreading buy points and avoiding the practice of “timing the market”. timing the market means throwing away all your money at once, and it can be a dangerous practice if you end up investing when a stock reaches its peak, risking a big loss if the stock falls from there. With dollar cost averaging, you’ll shop over time and average your purchase prices.
dollar cost averaging makes a volatile market work to your advantage. By adding money regularly, you’ll be buying at times when the market is lower, therefore lowering your average purchase price and actually buying more shares. When the market goes up, your regular contribution will buy fewer shares, but you’ll already have shares from previous purchases, so you’ll still earn and not lose out entirely.
In addition, dollar cost averaging can offer other benefits. People become fearful when stocks fall, and so to avoid further short-term losses, they stop buying stocks when they become cheap. By setting up a regular buying plan when the markets (and you) are calm, you’ll avoid this psychological bias and take advantage of falling stock prices when everyone else is scared.
You can accumulate even more shares if you also reinvest your dividends, which also applies the principle of dollar cost averaging to those quarterly dividend payments. Over time, you’ll convert your cash dividends into more shares, and you won’t have to do a thing once you set up the program. little by little you will start earning dividends on your dividends!
It only takes a little time up front to set up a rollover plan. then you put it on autopilot and let your broker take care of everything else. And that’s great for individual investors who want to spend as little time as possible dealing with their investments.
dollar cost averaging example
Imagine an employee who earns $3,000 each month and contributes 10 percent of that to his 401(k) plan, choosing to invest in an S&P 500 index fund. Because the price of the fund moves, the number of shares purchased is not always the same, but $300 is invested each month. the table below shows this example over a 10-month period.
You can see that the value of the employees’ investments increased by 8.4% over their $3,000 in total contributions, even though the fund only increased by 5% over the period. That’s because the employee was able to buy more shares when the price was lower, taking advantage of market volatility.
does dollar cost averaging really work?
It may depend on your specific situation, but dollar cost averaging has been a successful way for many people to invest over time. The question is whether you should time your purchases based on market conditions or just shop steadily over time using the dollar cost averaging method. Timing the market has been shown to be very difficult and most people are better off with a consistent investment plan.
Another problem is that most people invest money as they earn it, probably through a workplace retirement plan like a 401(k). Dollar cost averaging makes sense here because you’re investing what you can as soon as it’s available to invest. however, if you inherited a large sum of money, say $100,000, you don’t want to spread that out to invest over the years. In that scenario, it’s best to invest relatively quickly, but you could still spread the purchases over a few months to take advantage of potential volatility.
disadvantages of dollar cost averaging
The main disadvantage of dollar cost averaging is that, in a market that generally rises over time, it’s probably best to fully invest as soon as possible. But since most people save and invest as they earn money, dollar cost averaging is the next best thing.
another disadvantage is that you still need to choose good underlying investments. If your dollar cost averaging turns out to be a bad investment, the way you bought it won’t save you. The approach works best with broad-based funds, such as an S&P 500 index fund, that have performed well over long periods of time.
how to calculate the average cost in dollars
There are two ways to set the dollar cost average for your account: manually and automatically. if you go the manual route, you’ll just pick a regular date (monthly, bi-weekly, etc.) and then go to your broker, buy the stock or fund, and then wrap up until the next date.
If you go the automatic route, it takes a little more time up front, but is much easier later on. plus, it will be easier to keep buying when the market goes down, since you don’t have to act. While setting up auto purchase may seem like a daunting task, it’s actually easy.
Almost any broker can set up an auto buy plan, so use bankrate reviews from top players to find brokers that provide other features, such as great customer service and educational tools.
Here are the steps to make dollar cost averaging fully automatic.
1. choose your investment
First, you’ll want to determine what you’re buying. Do you want to buy shares? Or will you go for an exchange-traded fund (ETF) or a mutual fund?
- if you choose to buy an individual stock, it is more likely to fluctuate significantly than a fund will.
- if you buy a fund, it should fluctuate less than an individual stock and also more diversified, so you won’t be hurt as much if a single stock in the fund falls a lot.
less experienced investors tend to opt for a fund, and some of the more diversified funds are based on the standard & index of the 500 poor. This index includes hundreds of companies in all major industries, and is the standard for a diversified portfolio of companies. If you want to buy an S&P index fund, here are some of the best options.
in any case, you must enter the stock’s ticker symbol; that’s the shortcode for the action or background.
2. contact your broker
So, you’ve made your investment choice. Now see if your broker will let you set up an automatic purchase plan for that investment. if so, then you’re ready to move on to the next step.
However, some brokers allow you to set up an automatic plan with just ETFs and mutual funds or just stocks. In that case, you might consider opening another brokerage account that allows you to do exactly what you want. There are other solid benefits to having multiple brokerage accounts as well, and you can usually get a lot of value from having multiple accounts.
3. determine how much you can invest
Now that you have a broker that can execute your auto trading plan, it’s time to determine how much you can invest on a regular basis. With any type of stock or fund, you want to be able to leave your money in the investment for at least three to five years.
Because stocks can fluctuate widely over short periods, try to allow the investment to grow over time and outweigh any short-term price declines. that means you’ll need to be able to live on your uninvested money during that time.
so, starting with your monthly budget, figure out how much you can afford to invest. Once you have an emergency fund, how much can you invest that you don’t need? Even if it’s not much at first, the most important point is to start investing regularly.
dollar cost averaging is now cheaper than ever as all major brokers have reduced trading commissions to $0. that means you can really start with any amount of money and start building your savings.
4. schedule your automatic plan
You can set up the automatic trading plan in your broker using the ticker symbol for the stock or fund, how much you want to buy regularly, and how often you want the trade to run. the exact process for setting this up varies by broker, but these are the basics you’ll need in any case. If you have more questions, your broker can help.
and if your stocks or funds pay dividends, it may be a good time to set up automatic dividend reinvestment with your broker. Any cash dividend will be used to buy new shares, and often you can even buy fractional shares, putting the full value of the dividend to work, rather than having it for a long time in cash earning little or nothing. therefore, as soon as the next dividend, your dividend will generate dividends.
Dollar cost averaging is a simple way to help reduce risk and increase returns, and works to take advantage of a volatile stock market. If you set up your brokerage account to buy stocks or funds automatically and regularly, then you can sit back and do the things you love, instead of wasting time investing. By investing, you can often get better results with less effort.
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note: bankrate’s brian baker contributed an update to this story.