The key to saving for retirement is to start as soon as you can. Many would-be investors end up waiting on the sidelines because they feel like they don't have enough money to justify getting started. Yet with one basic strategy, you can begin putting your investment dollars to work right away and actually take advantage of favorable conditions right off the bat.
The strategy is called dollar-cost averaging, and not only does it fit well with the way most people budget their savings, it also does a good job of handling volatile markets. In fact, even as many of those who own stocks or exchange-traded funds that invest in stocks are antsy about the future, dollar-cost averaging offers opportunities that investors haven't had for years.
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The basics of dollar-cost averaging
Dollar-cost averaging sounds like a sophisticated strategy that involves having to make extensive calculations, but in reality, it couldn't be simpler. To use the strategy, simply figure out a dollar amount that you're comfortable investing on a regular basis. Then invest that amount as it becomes available, either from every paycheck or on a monthly or quarterly basis. The simplest way to use the strategy is with index mutual funds, because they allow you to purchase fractional shares to get your investment exposure precisely down to the penny. However, you can still use the strategy on individual stocks or shares of ETFs.
The benefit of dollar-cost averaging is that by investing the same amount of money each time, you'll end up buying more of an investment when its price goes down, and less when it gets more expensive. For instance, say that you have $240 to invest every month and are considering a stock that currently trades at $10 per share. The first month, you'd be able to buy 24 shares. But if the stock falls to $8 per share, your $240 will buy you 30 shares. Conversely, if the stock price rises to $12, then the same $240 will buy just 20 shares.
How dollar-cost averaging works in volatile markets
Dollar-cost averaging works fine when markets are moving up consistently, but its benefits really shine when markets are more volatile. For instance, take the example above and consider a situation in which the stock started the first month at $10, rose to $12 the next month, then crashed to $8 in the following month before recovering to the original $10 per share level. You might think that your portfolio would break even, because the stock started at $10 and finished at $10.
But as it turns out, you actually end up ahead with dollar-cost averaging:
|
Month |
Share Price |
Shares Bought With $240 |
Total Shares Owned |
|---|---|---|---|
|
1 |
$10 |
24 shares |
24 shares |
|
2 |
$12 |
20 shares |
44 shares |
|
3 |
$8 |
30 shares |
74 shares |
|
4 |
$10 |
24 shares |
98 shares |
Calculations by author.
By the end, you've invested $240 per month for four months, or a total of $960. But the 98 shares that you've bought are worth a total of $980. In other words, even though the stock ended up exactly in the same place where it started, you've already made a profit of $20.
How did this happen? Look at each position. You broke even on the shares you bought at $10, while the purchases at $8 per share gave you a $2 per share profit and the buys at $12 per share left you with a $2 per share loss. But you bought 30 shares when the stock was low compared to just 20 shares when the stock was high. That difference is what produced the extra gains.
Why dollar-cost averaging really makes sense
Critics of dollar-cost averaging note that it's not always the best strategy to follow when markets are rising. In particular, when you compare dollar-cost averaging to simply investing a lump sum of money all at once, getting money into the market faster unquestionably does better in favorable markets.
But the reality is that most people don't have lump sums of cash ready to invest. Budgeting a modest amount every month fits best with what the average American can truly afford, and taking advantage of the benefits of dollar-cost averaging is far smarter than not investing at all.
Whether you've been reluctant to start saving for retirement or just need a better plan for your investments, take a look at dollar-cost averaging. The ease of using the strategy makes it attractive for those who need to keep things simple, and its ability to take advantage of volatile markets can give you the peace of mind you want during periods of turbulence in the stocks you're interested in buying.
