When considering investing, one consideration is whether you want to invest the money all at once or over a period of time. If you choose the latter path, you may choose an investment strategy called dollar cost averaging.
With the average cost in dollars, you invest your money in equal parts, at regular intervals, regardless of the ups and downs of the market.
Let’s say you received a bonus or you saved up to $10,000 for an investment. Instead of investing that amount all at once, with an average dollar cost, you could split $10,000 into 10 parts and invest $1,000 per month for 10 months.
Perhaps you are already involved in calculating the average dollar cost and do not know it. If you have a 401(k) or another type of defined contribution plan, your contributions will be allocated to one or more investment options on a regular, consistent schedule, regardless of what the market does. Each time this happens, the average cost is in dollars.
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Before you start splitting your money, here are three things to know about the average dollar cost:
Why would someone consider calculating the average cost in dollars?
It would be great if we could buy stocks, or other types of investments, when the market is low and sell when the market is high. Unfortunately, “market timing” efforts often backfire, and investors end up buying and selling at the wrong time.
When stocks go down, people often get scared and sell. Then, when the market goes up again, they may miss out on potential gains. On the flip side, when the stock market is rising, investors may be tempted to impulsively. But they may end up buying just as the shares are about to fall.
Dollar cost averaging can help take the emotion out of investing. It forces you to keep investing the same amount (or roughly the same amount) regardless of market volatility, which can help you avoid the temptation of market time.
When your average cost is in dollars, you buy more shares to invest when the stock price is low and fewer shares when the stock price is high. This can drive a lower average price for the stock over time.
And by wading through, rather than handing over your money all at once, averaging your cost in dollars can help you limit your losses in the event of a market downturn.
What are the potential downsides to dollar cost averaging?
Dollar cost averaging can be a useful tool in minimizing risk. But investors who engage in this investment strategy may lose out on higher returns. With averaging the cost in dollars, you are holding your money as cash for a longer period, which has less risk but often results in lower returns than investing in the total amount, especially over longer periods of time.
If the market goes up during a period when the average dollar cost, you may miss out on the potential gains you could have had, had you invested right away in one fell swoop.
Of course, this doesn’t apply to something like a 401(k) because, in this case, you invest the money as you earn it, and you don’t keep the money in cash until a later date.
Also, keep in mind that if you engage in the dollar averaging cost calculation, you may face more brokerage fees. These fees may erode your returns. You also need to be disciplined with this money on the margins in order to eventually actually invest it and not be eroded by the purchases.
What is the minimum for investors?
As in all aspects of investing, it is important to consider potential returns as well as your tolerance for risk.
Investing all your money right away can yield higher returns than dodging small amounts over time.
But if you’re looking to reduce risk and control your emotions, or you’re concerned about volatile market conditions, dollar averaging can be a viable strategy — even if it means giving up some potential positives. If your main concern is to reduce your short-term downside risk and avoid feeling regret after a potential loss, then dollar cost averaging might be right for you.
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