No one can predict where the market is going at any given time, so why even try? Putting your money in an investment all at once - thinking it will only go up - can be a very risky idea.
By following a simple practice known as dollar cost averaging, you can protect yourself against market fluctuations and downside risk in the market. By buying a fixed dollar amount on a regular schedule, your focus is on accumulating assets on a regular basis, instead of trying to time the market.
Why dollar cost averaging makes sense
With dollar cost averaging, you take a lot of the emotion and fear out of investing because where the market goes in the short-term is far less important to you, as long as you stick to a regular investment plan. If a recession hits the economy and your investment falls in value, you’d just end up buying more shares at a lower price.
For example, let’s say at the beginning of this year, you put $100,000 all at once into a stock priced at $100 a share. By the end of the year, a recession or a dip in the market hits and the stock declines to $70, a 30% loss of $30,000.
Instead, what if you evenly distributed your money over the course of the year? Let’s say you decide to invest $25,000 each quarter. When the stock is down, you end up purchasing more shares, and when it’s up, you purchase less shares. This increases the number of shares you purchase and also decreases your average share price.
Instead of holding 1,000 shares valued at $70,000, and losing 30% or $30,000 on your initial investment, you’d hold 1,197 shares valued at $83,790, losing 16% or $16,210 on your initial investment.
Let’s take another example. Here, the stock starts the year at $100 per share, and then finishes at $90. If you bought at the start of the year, you’d have lost 10% or $10,000.
You could have made money dollar cost averaging, even if the stock ends the year down in price. At the end of the year, you would have made $4,580, compared to a $10,000 loss under the other scenario.
The bottom line is that with dollar cost averaging, you can reduce market risk and build your investments over time, regardless of where the market is going.
What you should understand
There are a few things investors should understand before starting their own dollar cost averaging plan:
Dollar cost averaging is a strategy that is better suited for investors with a lower risk tolerance and a long-term investment horizon. This strategy makes the most sense when used over a long period time with volatile investments, such as stocks, ETFs or mutual funds, and makes less sense for bonds or money market funds.
Next, the strategy is no guarantee of good returns on your investment. Dollar cost averaging into an investment that continues to fall each and every month is not a wise move.
Finally, investing involves risk and your own due diligence, so you should only dollar cost average into an investment that you understand and are comfortable with. You shouldn’t just set up an automatic investment plan and forget about the investment, either – it is probably a good idea to regularly check in on it.