The fear that you'll make a mistake like investing just before a stock market crash can make investing scary. That dread may be so great that it keeps you from doing anything at all.
Dollar-cost averaging is a strategy where you invest a pre-determined sum periodically throughout the year, usually monthly, and it can help alleviate this concern. With this process, you build your portfolio over time. Some months you'll get lower prices, and some months you'll get higher prices, but most importantly, you'll actively participate in the stock market and master it in these three ways.
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1. Time in the market
When the stock market plummeted in March due to COVID-19 concerns, you may have thought the downfall would last a long time and be more severe than it actually was. But the recovery was quick, and now new market highs have been reached. If you are someone who was waiting for an even deeper decline before investing money this year, you may still be sitting on cash.
The S&P 500 started off the year trading at 3,231, plunged to 2,237 on March 23, and is now trading at 3,703. If you exactly timed this bottom, you would've seen about a 65% increase in your accounts year to date. Timing this perfectly would've been very difficult, though. The markets did rebound, but they could've gone down further, and your outcome would've been drastically different.
Dollar-cost averaging lets you say goodbye to this guessing game and buy in at different prices throughout the year. If instead of trying to time the bottom, you'd decided that you would put $1,000 in an S&P 500 fund like the SPDR S&P 500 ETF Trust (SPY -0.05%) on the first trading day of every month, you would've gotten different prices throughout the year. Your purchase prices would've decreased monthly through April 1, but starting in May, you would've seen them mostly increase each month. Using this strategy, your return wouldn't be as high as if you'd been lucky and gotten in at the bottom. But it would be significantly better than if you'd done nothing at all and were still holding cash.
2. Better management of your emotions
The stock market is cyclical, so there will be bull markets, bear markets, and flat markets. If you are afraid that you will lose your nest egg if you put a lump sum of money into the market at the beginning of a bear market, dollar-cost averaging can help take away your apprehensions.
Imagine you invested $12,000 into the SPDR S&P 500 ETF at the beginning of the year. When the markets plummeted in March and the fund shrank by more than 30%, your $12,000 would've decreased to less than $8,400. Fearful of losing more, you might have even sold out of your investment with the plan of coming back to it when the markets stabilized, completely missing the market rally that followed.
With dollar-cost averaging, only a portion of your annual investment would've been subject to this deep decline. This lowered exposure and decreased loss could've made staying invested easier. In the following months, you may have even found yourself excited about buying your shares at lower prices and experiencing significant gains.
3. Long-term investment strategy
Creating a long-term investment strategy starts with having a plan. How much money will you need to reach your goal and how long will it take? Once you've answered these questions, you can figure out the best way of getting there.
You might be someone who can invest a lump sum of money at one time, but for many, it's more likely that you accomplish your goals by saving over time. There may be some plans that you already dollar-cost average into by default, like your 401k. Others, like an IRA or college saving plan, give you the option of funding with one lump sum or periodically. If you plan on contributing $6,000 into your IRA each year, coming up with that amount all at once might be hard. If you can't come up with this sum of money, you may even abandon the goal.
Breaking it down into monthly segments of $500 might make meeting it easier. Saving and investing this way can help you make it a habit rather than something that you do when you're able to. When it's something that you commit to regularly, you might find that you prioritize it better -- and it will give you a better chance of meeting your target.
Buying the wrong security or entering the market at the wrong time can be financially devastating. Now, instead of experiencing growth, you're starting off your journey at a loss. Not investing at all and saving with only your contributions can also make reaching important milestones difficult. Dollar-cost averaging can help you avoid these pitfalls and help you better achieve your financial goals.
