Regardless of how you go about it, you should get into the habit of paying yourself first. Unless you win the lottery or inherit wealth, the primary way to potentially build wealth is to save early and regularly, and invest those assets wisely. Dollar-cost averaging may be just the tool to help you along the way.
Dollar-cost averaging is the practice of regularly investing a set amount of money, regardless of market fluctuations. Choose your investment amount and frequency based on when you get paid — every two weeks, twice a month, every month — and stick with it.
“It’s a good technique for someone who has a lump sum they want to invest but is concerned about the value of the stock market plummeting,” says JJ Montanaro, a CERTIFIED FINANCIAL PLANNER™ professional with USAA. “It can also be good for someone who’s just getting started.”
Sounds complicated, but what is it?
Whether you know you’re doing it or not, if you regularly contribute to market-based investments in a 401(k) plan, an Individual Retirement Account or a 529 college savings plan, you’re already using dollar-cost averaging. The idea behind the approach is to limit the risk associated with investing at the “wrong” time by investing a fixed amount of money on a regular basis.
Consider the example below. Of course, this is an extreme example of stock price fluctuation, but it helps to illustrate the concept. Let’s say that you have $100 you’ve decided to invest each month, and you want to buy as many shares of stock as you can. The table below shows how your stock purchases might play out over a three-month period.
The first month, $100 will buy two shares of stock at $50 per share. In month two, the markets take off and the price of the stock soars to $100 per share, which allows you to only buy one share at $100. In the final month of this example, the stock tanks and prices drop down to $25 per share, which helps your $100 scoop up four shares at $25 each.
While it could be tempting to look at the performance of the stocks each month and try to invest your money at the best time, by dollar-cost averaging you’ve paid an average of just under $43 per share.
Part Investment Strategy, Part Psychology
“So much of investing is psychology,” Montanaro says. “When somebody who hasn’t had a lot of investing experience drops a lump sum of money in the market, they often get scared when the market drops. They suddenly want to pull their money out.” Dollar-cost averaging can be useful for these investors. It could allow them to stick with their long-term plan and avoid a rash move.
“There are more variables in the financial markets than in trying to predict the weather,” adds Julie Dahlquist, senior finance professor at the University of Texas at San Antonio. “Not only do we have the complicated mathematics, but we also have human emotion that must be factored in. I may be fearful that it’s going to rain today, but fear is not going to make it rain. But, if investors suddenly get fearful and go to pull their money out, that fear can move markets.”
Whether dollar-cost averaging or going all-in with an investment, a financial planner can help you decide on your investment strategy.