What is dollar-cost averaging? Put simply, it is making consistent purchases of stocks or bonds. Many people do this when they contribute weekly or monthly to a company retirement plan. Do you know its benefits?
Dollar-cost averaging adds one big benefit to a portfolio. That benefit is that you will be purchasing your stocks or bonds when prices are down as well as up. This means that the average price you pay for your securities has the chance to be less than if you bought all in at once.
Dollar-cost averaging is best done when markets are fluctuating up and down frequently in a sideways market. It is, also, beneficial in a dropping market. It is not as beneficial in an up market. That is because you would be continuing to buy shares at higher prices which defeats the purpose of dollar-cost averaging.
A good way to think of dollar cost averaging is going to the store for groceries. Letís say that you need eggs for this example. And letís say eggs normally cost $2.50 a dozen. But, when you get to the store, they are on sale for $2.00. Would you buy them? Most people would. The sale price is a deal. The same thing applies to dollar cost averaging. When stocks are rising, it is like the price of eggs going up. When stocks are falling, it is like when the eggs are on sale.
If you were to add up the total cost of eggs you purchased for the year, and then divide by the number of cartons purchased, you would get the average price paid for the eggs. You would probably find that the times you bought on sale reduced the average price you paid for a carton of eggs. This would have helped your budget.
The same applies to stocks and bonds. By buying in at regular intervals, you reduce the cost paid into the fund. This gives you better returns in the future since your average purchases were less per share. Obviously, if you could buy it at a steep market bottom, you would gain even more. But how will you know when that is? Even the professionals donít know. Dollar cost averaging solves this problem as well.
Dollar cost averaging can help spread your investing risk as well. By buying when the market is low, you can weather future low points better. You have more room to maneuver because you have not bought everything at the top.
An example can demonstrate this. Letís say you bought shares in Fund XYZ. Your initial investment of $1000.00 was made at a peak in the market. The next three months you bought in each month by $1000.00 dollars. Your share price were $45 in month one, $35 in month two, $60 in month three, and $40 in month four. You bought a total of 92.45 shares. Your average share price was $43.26, less than the $45 you would have paid if you had invested all at once.
Dollar-Cost Averaging has many benefits. It is advantageous to investors who do not have a lump sum to invest. Small investors can really benefit as they invest small amounts of money regularly.