Resources: Investing Basics: Dollar Cost Averaging
Does a long-term investment goal seem unreachable? Are you interested in investing, but worry the stock market will drop once you do? The answer in either case could be a tried-and-true investment technique: dollar cost averaging.
- Reaching for the unreachable
- Overcoming price volatility using dollar cost averaging
- Reduced cost
- A few things to remember
Dollar cost averaging is simply a method of investing the same dollar amount at a regular interval, such as once a month.
Dollar cost averaging takes little time or effort and can help you reach long-term goals. For example, imagine you're trying to save for your two-year-old child's college education. You figure out that in 16 years, when the child is ready to enroll, you will fall short of funding tuition by $80,000. Where will you find that $80,000?
You do the math and decide you can afford to put aside $200 a month. If you invest $200 every month and get a 10% rate of return over 16 years, that monthly contribution could grow to more than $80,000.
This example is hypothetical, and doesn't represent the actual results of a particular investment.
Dollar cost averaging can be an effective way to reduce the total purchase price of a portfolio of stocks. By investing the same amount every month, regardless of whether the market is up or down, you stay focused and disciplined. You also limit the risk of investing all your money when the market is at its peak.
In fact, many investors view market downturns as a buying opportunity since the share price of their target stock or fund may have fallen in price. While the overall value of your account may dip temporarily, you can buy more shares at a discount, lowering your overall cost per share.
A major benefit of dollar cost averaging is that it allows you to automatically reduce your average cost per share, by buying more shares when prices are low and fewer shares at higher prices.
Note: There may be transaction costs associated with each purchase that may increase the overall cost of investment.
For example, let's say John and Mary use dollar cost averaging and invest $200 a month. Here's what could happen:
- In January, ABC Fund is at $10 per share. So John and Mary's $200 investment buys 20 shares.
- The price of ABC Fund drops to $8 per share in February. John and Mary's $200 buys 25 shares.
- The price of ABC Fund rises to $12.50 in March. John and Mary's $200 buys 16 shares.
Over these three months, John and Mary buy 61 shares for $600. Although the average price per share is $10.17 ($10 + $8 + $12.50, divided by three), John and Mary pay an average of only $9.84 per share ($600 divided by 61).
|John and Mary's Dollar Cost Averaging|
|Monthly Investment||Share Price||Shares Purchased|
|Total: $600||Average: $9.84*||Total: 61|
* Average share cost is $9.84, while the average share price is $10.17.
While dollar cost averaging may help you reach your goals and ride the tide of fluctuating markets, there are a few important things to keep in mind:
- Take the long road. Making steady, regular investments works best for long-term goals, such as planning for college or retirement savings.
- Investing offers no guarantees. Dollar cost averaging does not assure a profit nor protect against losses in declining markets.
- Be committed. To use dollar cost averaging effectively, you must be prepared to continue investing steadily through periods of low and high prices.
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