With all the new technology and strategy buzzing around us these days, there are a few old-school, tried-and-true investment methods that seem to work consistently over time. One of those is dollar cost averaging; it’s designed as a long-term plan that helps keep your emotions, irrationality, and fear out of the investing process, where it might not belong.
With dollar cost averaging, you buy a fixed dollar amount of an investment on a regular schedule. The share price is not relevant here; the focus is on a regularly scheduled buy.
How it’s done: you’ll be purchasing more shares when prices are low and fewer shares when the price increases, but even more importantly, you will be on a solid and determined road that keeps surging your investment ahead, even during the temporary low points that could otherwise make you itchy to sell.
The Logic of Dollar Cost Averaging
At first glance, dollar cost averaging may not sound like a sound plan, but there is a method to its madness. Here are just a few reasons why it’s smart:
It forces you to stay the course. By investing the same amount of money every month, you will buy more shares when the market is down and less shares when the market is up. The key is investing the same dollar amount every month no matter how you feel about the market that day. That’s a great practice of strength to learn when investing.
It allows you to set it and forget it. A regular dollar amount every month keeps it simple and uncomplicated. You don’t have to keep your eye on the investment or market volatility.
It lets you invest a small amount of money, or at least as much as you can afford. You don’t have to be wealthy in order to use the dollar cost averaging method. You can start small, but all the while, you will be contributing to and growing an investment portfolio.
It keeps you from trying to “time the market.” Dollar cost averaging changes your investment priorities from trying to time what the market is going to do to keep your head down and sticking with a consistent investment strategy.
You may be able to save yourself a lot of stress and heartache by avoiding the guessing game, and over the long term, the average investor will earn a higher return than if they tried to time the market.
It increases your chances of being in the right place at the right time. Without having to second guess when the market will reach its peak, and then having to buy and sell, you’ll already be where you need to be, without having to get there.
Think of it as a formula that adheres to the old expression “slow and steady wins the race.” The safety comes with time: you’re spreading the cost basis of the investment over a long period, protecting yourself against the ups and downs of the life of a typical investment. You’ll sometimes buy low and you’ll sometimes buy high, but the idea is to have it all even out in the end.
Say you can invest $100 every month. You won’t be able to buy as many shares when the market is up and your shares cost more. However, when the market goes down, that $100 will buy more shares. In the long run, your average cost per share could be lower than if you bought all of your shares at once.
Options to Invest In
You can use dollar cost averaging to invest in a variety of things, really; however, there are specific investments that really seem to thrive with this system:
Mutual Funds: Mutual funds allow you to purchase a share, which represents a very small allocation of the underlying investment portfolio. This means that you can diversify with much smaller dollar amounts than if you purchased the securities on your own.
ETFs (exchange-traded funds): Similar to mutual funds, ETFs provide an opportunity to diversify with smaller dollar amounts. Additionally, ETFs are available to trade throughout the day, generally have low expenses, no investment minimums, and offer greater tax-efficiency.
Dividend Reinvestment Plans. Rather than receiving dividends via check or direct deposit, some companies allow you to automatically buy additional shares with the dividends. This approach would purchase additional shares of the stock you already own, so it would not provide any additional diversification.
How To Set Up a Dollar Cost Averaging Plan
You can do it in three easy steps:
Determine your regular investment amount for each month. If this is going to be true dollar cost averaging, the time to make this decision is right at the very beginning, before you invest even one cent. Make sure it’s amount you can afford, even as life changes.
Determine the investment pattern. This could be weekly, bi-weekly, monthly, or quarterly. For the most convenience, you may want to consider setting up an automatic withdrawal from your checking or savings account. Find the right long-term investment.
You may want to consider a financial advisor to help arrive at a decision that makes you feel right. Think of this investment as long-term (a retirement or college fund, for instance). This should not be the kind of fund that you dip into for fun or for emergencies.
An Example of Dollar Cost Averaging
Here’s a very basic sample of dollar cost averaging:
|Average Price Per Share: $9.19|
As you can see in this example, the price per share will fluctuate up and down. By contributing the same amount every month, you simply bought more shares when the price was low and less shares when the price was high. The key to your success will be consistency: regular contributions.
Getting Your Dollar Cost Average Priorities Straight
It’s not about picking stocks. It’s about being disciplined and consistent. If you’re not a natural-born stock picker (and most people aren’t), it may be a good idea to get with a financial advisor who can help you or leverage an automated solution. This will save you from second guessing or going into a periodic panic mode; instead, you can focus on the real matter at hand; steady regular investments.
Seven Mistakes To Avoid When Dollar Cost Averaging
According to U.S. News and World Report , as simple as the method is, some investors don’t understand how to best use it to their advantage. The bottom line: the only way dollar cost averaging will work is if you follow the rules.
Here are the mistakes to avoid:
1. Failing to Recognize the Benefits at an Early Age
Dollar cost averaging instills investing discipline, which is a valuable lesson to learn early on. When you’re first starting out, it’s often difficult to take a long view of your future.
However, making dollar cost averaging a priority from the get go, and opting for regular, automatic investments that you don’t even have to think about, will get you on your way with a minimum amount of fuss.
2. Not Investing Consistently
Waiting for the market to change before taking action is going to make your contributions uneven and ultimately ineffective. A stop-and-start approach means that you will need to pay more attention to the investment, whether you have the time to do so or not. Plus, investing this way is a definite time suck.
3. Forgetting to Rebalance
In order to help reduce volatility, it may be a good idea to keep your stock portfolio diversified. As the market changes, your original game plan for your overall portfolio (as opposed to just one stock) may need to be reviewed and altered to adjust to changes in the market. Scroll down below; we talk all about portfolio rebalancing and how it can help keep your investment healthy and strong.
4. Having Second Thoughts About Dollar Cost Averaging
If you watch the market and you think it may be time to give dollar cost averaging a rest for a while, you automatically become a slave to trying to time the market. Most financial advisors discourage this and tell you to stay the course and stick to the system.
5. Confusing Dollar Cost Averaging With not Paying Attention to Your Investment
The dollar cost averaging strategy is not necessarily self-sustaining forever. You will need to periodically review your investment to see if you need to alter your plan.
Ideally, you should review your plan annually to make sure your investment strategy still aligns with the amount of risk you are comfortable taking and that you are saving enough to meet your goals.
6. Taking Too Long to Invest a Lump Sum
Invest a lump sum perhaps a bonus, tax refund or gift all at once, rather than divide it into 12 monthly installments. Cash not invested will not be working for you.
7. Ignoring Trading Costs and Transaction Fees
It depends on your broker or financial advisor, but pay attention to your trading and service fees. They certainly add up, and affect your final investment result.
A Word About Rebalancing Your Portfolio
The periodic rebalancing of your portfolio is easy to overlook, especially when the distractions of life get in your way. However, it’s recommended to do this once or twice a year.
The concept of rebalancing is actually very similar to dollar cost averaging. Dollar cost averaging is a disciplined, repeatable, and unemotional process to contribute money on a regular basis whether the market is up, down, or even. This results in a lower average cost per share over the long term.
Rebalancing is simply taking a similar approach but applying it to your overall investment portfolio as your investments go up and down in value as the market fluctuates.
Another term for this is asset reallocation, or adjusting the percentages of how much of your money is invested where. Typically this process starts by grouping investments together with other similar investments called asset classes.
That includes U.S. stocks, international stocks, high-yield bonds, real estate, and short-term treasury bonds. The money you put into these asset classes should be divided up according to your goals and comfort level.
That means that at the end of the day, your portfolio should ideally be sticking to your original plan and goals, and continuing to adhere to your risk tolerance and timeframe (like retirement, for instance). It’s simply a periodic fine tuning.
On the surface, the basic process of rebalancing just sounds wrong: selling off the asset classes that outperformed your expectations, and using that money to buy more of an asset class that didn’t do as well.
It seems to make no sense to sell off a winning stock to sink money into a weaker one, but that’s all part of having a diversified portfolio. But again, it’s all about evening it out and giving some love to the investments that may need a little more fuel to get going. This is similar to dollar cost averaging in which you simply bought more shares of a security when the price was lower.
You can work with an advisor to help you consider your rebalancing strategy, but check first to see if there is a fee for doing so. Also, if your investment is not part of a tax-deferred retirement account like a Traditional IRA or a 401(k), you may incur taxes when making changes to your investment strategy. That’s true even if you simply rebalance as described above.
About SoFi Invest®
You can get started implementing a disciplined approach to investing using dollar cost averaging with SoFi Invest. SoFi Invest offers an active solution for do it yourself investors who want to pick and choose their investments while paying no trading fees or commission.
SoFi Invest also offers an automated solution for investors who want a diversified strategy without having to make the decisions themselves while paying no management fees. Either way, you will have access to financial advisors who can help you along the way.
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