Dollar-cost averaging is a fancy term for investing small amounts of money on a consistent monthly basis, as opposed to in a large lump sum once a year or so. For instance, let’s say you invest $100 in a mutual fund that is currently selling at $10 per share. You would have bought 10 shares ($100 divided by $10 per share). Next month, the price of the fund drops to $5 per share and you invest $100 again, this time buying 20 shares. In the third month, the fund price increases from $5 per share to $7.50. You invest another $100, this time buying 13.3 shares.
If you total your shares for the three months, you would find that you have 43.3 shares. If you then multiply the 43.3 shares by the latest fund price of $7.50, you would find that your account is now worth about $324.75. That’s $24.75 more than you invested — even though the share price is still below the original starting price of $10.
Automatic contribution plan
Another great benefit of dollar-cost averaging is that many mutual fund companies will waive their required minimums for investors who set up automatic contribution plans.
Keep in mind that dollar-cost averaging does not protect against losses in declining markets. If all the market does is go down, it really doesn’t matter how often or when you invest, you’re going to lose money.
There’s another school of thought regarding how to invest: lump sum investing. As the name implies, you put the entire amount in at one time. If you had $10,000 to invest, instead of dollar-cost averaging it into the market every month over a year or two, you would invest the entire $10,000 at once. The reasoning is, if you think the market will be higher over time, why not put all of your money to work for you immediately? If the reason we’re all investing in the first place is to make money and if we expect the market to be higher over the years, (even taking into account all of the ups and downs), then this approach certainly makes some sense, too.
There are a few reasons, however, why I believe most people would be better off dollar-cost averaging their investment monies. First, many people don’t have a lump sum to invest. (That’s a big roadblock to lump sum investing.) What they do have is a certain amount of money from their paycheck to invest monthly. Second, if you put a lump sum into the market right before the market has a big correction (a correction is when the market drops to better align stock prices with their earnings) and see 20-30 percent or more of your investment erode almost immediately, you might be psychologically unable to deal with it. You might want to take out all your money, which is almost always a bad move. That would just cause you to lock in whatever losses you just suffered.
Third, if you were dollar-cost averaging a lump sum and the market did correct, you would have the option of putting a lump sum in at that time and buying at a much lower — and therefore better — price. Both lump sum investing and dollar-cost averaging have merits, so you need to decide which is best for you.
Tags: investment advice, financial advisor, retirement planning, financial advice, personal finance, compound interest, tax-deferred growth