Understanding and Setting Up Dollar Cost Averaging

April 17, 2017

If you have been having trouble investing money, you might want to give dollar cost averaging a serious try. It’s the non-investors best strategy for becoming an investor. It puts your investment activities out of sight and makes them automatic. As well, you won’t have to make any difficult investment decisions. All you have to do is start the process, and then sit back and relax.

What is Dollar Cost Averaging?

Dollar cost averaging is an investment accumulation method in which you invest a fixed amount of money into one or more investments on a set schedule. The method virtually ignores both market timing and the actual price of the investments being purchased.

An example of dollar cost averaging is when you use payroll deductions, such as $100 per paycheck, to put money into a mutual fund or an IRA. Every time you are paid, the money goes into the designated investment fund. There it is used to automatically purchase certain predetermined investments. So, if your money were going into a mutual fund, your payroll deduction would be used to purchase $100 of additional shares in the fund.

Dollar cost averaging has the effect of enabling you to purchase more shares when stock prices are lower, and fewer shares when they are higher. For example, if the share price of a given mutual fund is $10, and you allocate $100 to the fund, you will purchase 10 shares. But if the price of the shares were to rise to $20, you would purchase only five shares.

This arrangement can be a benefit to you in both rising and declining financial markets.

How Dollar Cost Averaging Protects Your Investments in a Rising Market

Since you are purchasing fewer shares of whatever investment you are making when prices are higher, you will be accumulating fewer shares at higher prices.

This is where the “averaging” part of dollar cost averaging becomes effective. Rather than purchasing a lump sum of say, 100 shares of a stock at $20 per share, you are instead purchasing them gradually over a long period of time. Had you started purchasing the same stock one year ago, when the price was $10 per share, you would have accumulated 100 shares at an average price of $15 per share.

That would mean that your total investment would be $1,500, and not $2,000. If in that time the price of the stock has since risen to $20 per share, you would see a $500 gain as a result of purchasing the stock gradually.

How Dollar Cost Averaging Protects Your Investments in a Falling Market

The same benefit happens when stock prices are falling. Using the same example as above, were you to purchase 100 shares of stock at $20 per share in a single transaction, you would have to $2,000 of your money at risk with that particular investment. Should the price of that stock fall to $10 per share, you would lose $1,000, or half of your investment.

But if you purchased the same stock using dollar cost averaging, at an average price of $15 per share over the past year, your total investment would be $1,500. Should the price of the stock fall to $10, you would only be down by $500.

The fact that you acquire an investment gradually means that you are spreading the cost of that security over the long term. That will keep you from buying into an investment at a high price, which holds the potential for you to lose considerably more money if the security price drops.

With Dollar Cost Averaging You Never Have to Worry About Timing the Market

One of the more relaxing features of dollar cost averaging is that you never have to worry about timing the purchase of your investments or the financial markets. Since you are buying into your investment positions on a gradual, long-term basis, you never have to concern yourself with purchasing that investment at the most opportune moment or price.

That removes the need to track the investment price waiting for the best moment. You simply have to decide which investments you want to get into, and then coordinate your dollar cost averaging strategy to fund those positions.

Keeping Your Emotions Out of Your Investments

One of the factors that consistently undermines the average investor is human emotion. Since investing involves seeking gain and risking a loss to your hard-earned money, it can be very difficult to keep your emotions under control in the process. That can mean that you could potentially make investment decisions – to buy or to sell – based more on feelings than on facts and logic.

For example, it’s very common for small investors to load up on stocks near the peak of a bull market. While that may somehow seem to be a safer time to invest, it’s also when you will be buying into investment positions at the highest prices. That can set you up to take huge losses when the market reverses.

At the opposite end of the spectrum, small investors typically avoid the financial markets during bear markets. After the markets have taken a serious negative turn, people naturally prefer to avoid investing at all. And yet bear markets are the best time to buy into any investment position!

If you use dollar cost averaging to accumulate and invest your money, you will be buying stocks and mutual funds at or near their low points in bear markets. What’s more, since share prices will be low, you will be purchasing more shares in every investment that you get into. That will put you in a position to reap major gains when the market turns up once again.

Putting Your Investing on Automatic Pilot

Since dollar cost averaging is set up to be an automatic process, it virtually puts your investing activities on automatic pilot.

If you have accumulated a significant amount of money in an employer-sponsored retirement plan, such as a 401(k) or 403(b) plan, then you can appreciate the benefits of gradual but relentless investing. Though you might be making what seem to be small periodic investments, over time, you can build up a substantial five-figure or six-figure investment portfolio.

It happens because you have set up automatic investing. That investing is a form of dollar cost averaging. You can do the same thing when it comes to non-retirement accounts. Simply set up to fund certain investments using either payroll deductions, or regular manual contributions to your chosen investments. In no time at all, the same thing that is happening with your retirement account will happen with your non-retirement accounts.

For most people, dollar cost averaging will be the best way to accumulate investments, either over the short-, medium-, or long-term.

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