If you find yourself with a lump sum of money -- whether from a bonus, inheritance, winning the lottery, or any event of sorts -- you may be tempted to invest it all at once. However, using the dollar-cost averaging investment strategy may be a better way to put your money to work. Even if you don't have a lump sum to invest, using dollar-cost averaging is a great strategy to help anyone ease into investing.
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How dollar-cost averaging works
Dollar-cost averaging involves investing specific amounts of money at regular intervals, regardless of the price at the time. For example, if you have $10,000 you're able to invest, instead of buying $10,000 worth of stocks at once, you may decide to break it down like the following:
- Weekly: $10,000 / 52 weeks = $192.31 each purchase
- Monthly: $10,000 / 12 months = $833.33 each purchase
- Quarterly: $10,000 / 4 quarters = $2,500 each purchase
An excellent example of dollar-cost averaging happens within 401(K) plans, where employees select a set amount of their salary to invest in chosen investments. Each paycheck, that money is invested regardless of the investment's price at the time.
The frequency of your investments doesn't matter as much as making sure you're consistent and sticking to the schedule you set for yourself.
Avoid trying to time the market
"Time in the market is more important than timing the market" is an investment saying that has stood the test of time. Using dollar-cost averaging removes the temptation of trying to time the market -- which is extremely hard, to say the least -- and making irrational investment decisions. Nobody knows when the market will crash or drastically decline. Using dollar-cost averaging helps ensure you don't invest a lump sum right before a major market drop.
The Vanguard S&P 500 ETF (VOO +0.29%) closed at $283.87 on March 2, 2020. The next day, the stock market reached lows that we hadn't seen in more than a decade, and the fund's price dropped to $204.27 at closing. Exactly one year later, the fund closed at $359.41, meaning the difference between buying $10,000 worth of shares on March 2, 2020, and buying on March 23, 2020, is more than $4,900.
Of course, hindsight is 20/20, but dollar-cost averaging helps eliminates the desire to want to time the market. It helps investors focus on the long-term and sticking to a schedule instead of daily stock price movements, which can be stressful.
Removing the emotions from investing
It's easy for investors to let their emotions impact their decision-making. Some may see prices rising and buy more even though the investment is overvalued, while some may see prices declining and start panic selling instead of focusing on their long-term goals. Either way, these emotional decisions are usually counterproductive -- particularly when the stock market is highly volatile.
It can be stressful finding the "right" time to invest, especially when it's a lump sum involved. Instead of putting that stress on yourself, it's a good idea to break down your lump sum into periodic investments using the dollar-cost averaging method.
Who can benefit from dollar-cost averaging
Everyone can benefit from dollar-cost averaging, but it's especially useful for new and long-term investors. If you're investing for the long-term, you shouldn't be as concerned with the daily changes in stock prices. If you know you're holding on to a stock for years -- which I recommend -- the daily price fluctuations aren't as important as the stock's performance in the long term. And if you're investing in sound companies, they should perform well.
