What is dollar-cost averaging?
Dollar cost averaging is an investment strategy that is sometimes referred to as a constant dollar plan. The strategy involves making an investment in fixed dollar amounts over a specified time period as opposed to just making the whole investment all at once. The amount of money invested each time remains the same throughout the course of the strategy. A relatively simple strategy, dollar-cost averaging is a common practice among professional money managers and investment advisors alike, and is used predominantly with more volatile investments like equities. You may already be practicing dollar-cost averaging if you contribute regularly to an employer sponsored retirement of investment plan, as you are putting in the same dollar amount every pay period.
The future price movement of a particular investment, say a stock, will always be uncertain and there is really no way of knowing when a bottom has been reached. With dollar-cost averaging you do not have to commit to one price at any particular time by spreading out your investments into smaller units. This is why throughout the course of the strategy the number of shares purchased will vary while the amount of money invested will stay the same.
The most basic justification for using dollar-cost averaging is that you will buy more shares when prices are lower and fewer shares when prices are higher. Think of dollar-cost averaging as a risk management tool. The concept of timing the market is totally eliminated from the equation because you are scheduling your entrance into the investment beforehand. Implementing this strategy also takes the emotion out of the ordeal, which is something we often bring to the investing table as humans. Instead of diving head first into the investment, with dollar-cost averaging you are easing your way into a position over time.
Putting a plan into action
Let's say you wanted to invest $10,000 in XYZ stock that's currently valued at $10 a share. If you were to invest the $10,000 all at once, you would be committing to a cost per share of $10. Fast forward a week; XYZ becomes embroiled in a scandal that sends investors running for the hills. If the price of XYZ falls to $6 a share, you will find yourself $4,000 in the red. Now let's say you pursued a dollar-cost averaging strategy with the same $10,000 with a plan of buying $1,000 worth of XYZ every month for 10 months. With a dollar-cost average strategy in place, you would have been able to purchase XYZ stock at $6 a share rather than at $10 a share. In any situation where the market goes through a downturn, the worst that can happen is that you buy more shares at a cheaper price. This is how the strategy acts as a safety measure for fluctuating prices.
Now let's say that XYZ's share price instead jumped from $10 a share to $13 a share because of positive earnings. It could easily be the case that you make your second monthly XYZ purchase at $13 a share. You might be thinking that with our implemented strategy of purchasing $1,000 a month of XYZ for a 10-month period that you would be losing out on a profitable trade by purchasing XYZ above a $10 share price. But this is the wrong perspective because dollar-cost averaging is a risk management tool and is designed to protect against the downside. We can never time the market with 100% accuracy, and we shouldn't ever try. However, we can position ourselves to navigate the market's volatility without losing our shirts. It may only seem like you are savings pennies at times with this strategy, but over the long term these pennies add up to a much lower average cost per share.
Use dollar-cost average when selling as well
Just as it can be useful for buying, dollar-cost averaging can be a savvy strategy for selling. Instead of selling your entire position all at once, you would cash out in increments over a set period of time. This strategy is sometimes referred to as reverse dollar-cost averaging. This offers you the same benefits as when you are buying.
If a dollar-cost averaging strategy fits your particular investment situation, it is important to set up a plan but even more important to stick with that plan. Many investors will begin a dollar-cost average strategy only to pull the plug after a sharp market turn. This move will make the initial strategy pointless. As with all investment activities, stay on course and always keep the objective in mind.