When you enter the world of investing, the terminology alone can be enough to send even the most well-read into a panic. Between words like fiduciary, bull and bear market, dividends, diversification, and a whole slew of acronyms like ETFs, SEP, IRA, FAANG, IPO, etc., it’s easy to feel overwhelmed by the information.
Recently, I’ve been asked over and over again about one phrase in particular –– dollar-cost averaging.
I keep hearing about dollar cost averaging and don’t really understand it. How is it different from other investing strategies, and how will it help me in the long run?”
What is Dollar-Cost Averaging?
The simplest explanation behind dollar-cost averaging is a strategy that takes advantage of the fluctuations and unpredictability of the market by remaining steadily predictable. Most investors do this by determining a set amount that they will invest each month and doing so regardless of the price of their investments.
Each investor has their preference, but this might look like setting up an automatic $200 (or $500, $1000, etc.) per month across your investments or in a particular stock over time.
In the most basic sense, it’s no different than setting up an auto-savings transfer to your savings account when you get paid.
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The Advantages of Dollar-Cost Averaging
What makes this automated form of investing a great long-term strategy? The idea behind dollar-cost averaging is the statistical probability that the market, even when it’s volatile, is mainly moving in an upward trajectory.
In the last 100 years, the market has seen a return of 10% each year on average. The phrase “on average” is important to remember. This 100-year time span includes several recessions and market crashes, and yet it still ends up averaging out in the investor’s favor time and time again.
When you use dollar-cost averaging as a method, you’re investing the same amount each month and holding your money for the long term, so even if a stock dips or we hit another recession, you’re likely to still benefit on the other side.
This long game approach is likely also much better for your stress levels. Day traders and short-term investors are constantly watching every stock they own like a hawk. It’s almost a full-time job in and of itself to keep track of the market’s daily and sometimes hourly fluctuations.
When utilizing dollar-cost averaging, you won’t be as worried by news headlines, dips, or peaks. Sure, you might only get a few shares one month and twenty the next with the same amount of money, but it all rounds itself out in the end.
What Happens If the Market Crashes?
As I mentioned above, the average return over the last 100 years should give you some comfort in the case of market crashes. It’s most likely that we’ll see one or many more crashes (or at the very least, recessions) in our lifetimes. But historically, the market has always rebounded.
Dollar-cost averaging keeps you from rushing into either panic buying or panic selling your stock whenever there’s a hiccup in the market. Think of it as the “set it and forget it” of investing techniques.
A Simplified but Powerful Illustration
Here’s a quick example of the benefit of dollar-cost averaging over time. We’re using a 3-4 year window and approximations to help illustrate this example. Keep in mind, this illustration is incredibly oversimplified but should drive the point home.
Let’s say you’re buying stock XYZ. When you put in your initial investment, the average price of stock XYZ is $10 a share. You decide to invest $1,200 a year ($100 a month), buying you 120 shares that year.
The following year, your $100 a month goes in, but this time the average price of stock XYZ is $20 a share. So you buy 60 this time with your investment over the course of the year. This might be where other investors get nervous and start dumping their shares — but not you! You’re riding the wave.
In the third year, stock XYZ plummets to $1 a share, and this time you’re able to buy 1,200 total shares with your automatic investment.
In 3 years, you’ve bought 1,380 shares for a $3,600 investment. The next year, the share rocks back up to $5, and you decide to sell. You now have $6,900 worth of shares, giving you a base return on your investment of $3,300.
What if you had sold at $20 in year two when others started to panic about the nosedive? You’d end up with $3,600 after spending $2,400, leaving you with a base return of only $1,200. Still not bad, but a fraction of what you could have made if you’d held out a little longer.
Things to Consider
Something to keep in mind with dollar-cost averaging is that it can be beneficial to start with a larger sum as your initial investment and then add to it in smaller increments over time. Remember, compound interest is your best friend in investing, so the larger amount you begin with, the more you’re building as you go, even with smaller monthly contributions. But, if you don’t have a larger starting sum, that’s OK — you’ll still see the benefits.
You can use this dollar-cost averaging method in any investment account, including your retirement accounts like IRAs and 401ks.
Dollar-cost averaging is an excellent strategy for investing in the market without the stress of trying to time it. When it all comes down to it, “time in the market” will always fare better over “timing the market.”
Want to better manage your investments?
To track mine, I use Personal Capital’s free and secure online financial tools to see all of my accounts in one place, analyze my investments and uncover hidden fees, and plan for my long-term goals, like saving for retirement.
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