Dollar-cost averaging is a simple technique that entails investing a fixed amount of money in the same fund or stock at regular intervals over a long period of time.
If you have a 401(k) retirement plan, you're already using this strategy.
Make no mistake, dollar-cost averaging is a strategy, and it's one that almost certainly will get results that are as good or better than aiming to buy low and sell high. As many experts will tell you, nobody can time the market.
How to Invest Using Dollar-Cost Averaging
The strategy couldn't be simpler. Invest the same amount of money in the same stock or mutual fund at regular intervals, say monthly. Ignore the fluctuations in the price of your investment. Whether it's up or down, you're putting the same amount of money into it.
The number of shares purchased each month will vary depending on the share price of the investment at the time of the purchase. When the share value rises, your money will buy fewer shares per dollar invested. When the share price is down, your money will get you more shares.
Over time, the average cost per share you spend will probably compare quite favorably with the price you would have paid if you had tried to time it.
Rewards of Dollar-Cost Averaging
In the long run, this is a highly strategic way to invest. As you buy more shares when the cost is low, you reduce your average cost per share over time.
Dollar-cost averaging is particularly attractive to new investors just starting out. It's a way to slowly but surely build wealth even if you're starting out with a small stake.
Example of Dollar-Cost Averaging
For example, assume an investor deposits $1,000 on the first of each month into Mutual Fund XYZ, beginning in January. Like any investment, this fund bounces around in price from month to month.
In January, Mutual Fund XYZ was at $20 per share. By Feb. 1 it was at $16, by March 1 it was $12, by April 1 it was $17, and by May 1 it was $23.
The investor keeps steadily putting $1,000 into the fund on the first of each month while the number of shares that amount of money buys varies. In January, $1,000 bought 50 shares. In February, it bought 62.5 shares, in March it bought 83.3 shares, in April it was 58.2 shares, and in May it was 43.48 shares.
Just five months after beginning to contribute to the fund, the investor owns 298.14 shares of the mutual fund. The investment of $5,000 has turned into $6.857.11. The average price of those shares is $16.77. Based on the current price of the shares, the investment of $5,000 has turned into $6,857.11.
If the investor had spent the entire $5,000 at once at any time during this period, the total profit might be higher or lower. But by staggering the purchases, the risk of the investment has been greatly reduced.
Dollar-cost averaging is a safer strategy to obtain an average price per share that is favorable overall.
Why Use Mutual Funds
When it comes to using the dollar-cost averaging strategy there may be no better investment vehicle than the no-load mutual fund. The structure of these mutual funds, which are bought and sold without commission fees, seems almost to have been designed with dollar-cost averaging in mind.
The expense ratio that mutual fund investors pay is a fixed percentage of the total contribution. That percentage takes the same relative bite out of a $25 investment or regular installment amount as it would out of a $250 or $2,500 lump-sum investment. Compared to, say, stock trading in which a flat commission is charged for each transaction, the value of the fixed-percentage expense ratio is startlingly clear.
For example, if you made a $25 installment payment in a mutual fund that charges a 20 basis-point expense ratio, you would pay a fee of $0.05, which amounts to 0.2%. For a $250 lump-sum investment in the same fund, you would pay $0.50, or 0.2%.
If you made a $25 investment through a broker who charges $10 commission per trade, you pay $10, which amounts to a 40% fee. A $250 would involve a fee of $10.00, or 4%.
An online discount broker would certainly cost less, as they typically charge a flat $4.95 per transaction.
Still, the availability of no-load mutual funds, which by definition do not charge transaction fees, combined with their low minimum investment requirements, offers access to investing to almost everyone. In fact, many mutual funds waive required minimums for investors who set up automatic contribution plans, the plans that put dollar-cost averaging into action.
To really cut the costs, you might consider index funds or exchange-traded funds (ETFs). These funds are not actively managed and are built to parallel the performance of a particular index. Since there are no management fees involved, the costs are a fraction of a percentage.
A Long-Term Strategy
Regardless of the sum you have to invest, dollar-cost averaging is a long-term strategy.
While the financial markets are in a constant state of flux, over long periods of time most stocks tend to move in the same general direction, swept along by larger currents in the economy. A bear market or a bull market can last for months or even years. That reduces the value of dollar-cost averaging as a short-term strategy.
In addition, mutual funds and even individual stocks don't, as a general rule, change in value drastically from month to month. You have to keep your investment going through bad and good times to see the real value of dollar-cost averaging. Over time, your assets will reflect both the premium prices of a bull market and the discounts of a bear market.