Investing strategies: How dollar-cost averaging makes you money

There’s no right or wrong way to strategize when it comes to investing. But dollar-cost averaging might be right for you –– particularly if you can trust your stocks and funds to increase in value over time. Here’s what you need to know about dollar-cost averaging.

What is the dollar-cost averaging?

Dollar-cost averaging is an investment strategy that involves contributing a fixed amount to a fund or stock portfolio at regular time intervals, regardless of share prices or market movements at any given time.

When the prices of your chosen stocks or funds go up, your fixed investment will buy fewer shares. When prices go down, it nets you more shares and reduces your average cost per share over time. This way, your investment isn’t as highly impacted by volatility as it would be if you purchased all your shares in one lump sum.

This is often practiced with index funds, so that you’re dropping money into the S&P 500 or the Nasdaq Composite regardless of the price at the moment. You’re betting that markets go up over time.

Dollar-cost averaging removes the guesswork that comes with timing the market or any group of stocks and buying at the right time.

Using dollar-cost averaging

Let’s say you decide to invest $1,000 in stock ABC on the first of every month for five months. Assume the following table indicates how the price of the stock moves in the first five months.

By May, a total investment of $5,000 ($1,000 X 5 months) is worth $5,527.50. Had you decided to invest that total at any one of those months, your investment may be larger or lower. In this case, the average price of the stock was the same as the purchase price. But it’s lower than the stock’s highest price.

By using this strategy, you reduced the impact of volatility in the stock price over time.

Benefits of dollar-cost averaging

Dollar-cost averaging steers you away from the risk of market timing. Because you’re investing a fixed amount at different intervals regardless of share price, you avoid emotional investing or buying more shares as prices rise and panic selling when they drop. Dollar-cost averaging keeps you on a steady, long-term investing strategy.

Dollar-cost averaging is so well-regarded, it’s used in retirement planning. If you own a 401(k) plan, you’re already doing it. Your employer takes a fixed amount of money out of your check every payday and invests it in the stocks or funds you’ve chosen for your 401(k).

Risks of dollar-cost averaging

Succeeding in dollar-cost investing assumes share prices will rise, at least in the long run. But prices are constantly moving, and nobody can predict where they’re heading. So engaging a dollar-cost averaging strategy on a stock you know little about can be especially risky. You may end up buying more shares at a time when an exit would be more suitable.

That’s why dollar-cost averaging may be more suitable for index funds or mutual funds, which invest in a variety of different stocks. But in either case, it’s crucial to examine the fundamentals of any investment before employing a strategy.

Moreover, dollar-cost averaging is best used as a long-term strategy. While markets are in constant flux, prices generally don’t change much in the short term. You have to keep your dollar-cost averaging strategy in play through a long period to benefit from the low prices of a bear market and the high prices of a bull market. Either can last several months or even years.

Automatic investing plans

Many brokers provide automatic investing plans. These strategies allow you to contribute fixed amounts of money automatically from your bank account to securities such as a mutual fund at set time intervals. Here are some top picks.

Before you kick off your dollar-cost averaging strategy, you’ll need a broker to do it with. Here are some of your choices.

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Bottom line

Dollar-cost averaging is the process of dividing your total investment in a stock or fund into fixed investments at set time intervals. When done correctly, it can help you hedge against volatility and earn strong profits in the long run. Before you invest, compare stock-trading platforms to find one that’s right for you.