What Is Dollar-Cost Averaging and How Does it Work?
If you’re taking your first steps into the world of investing, you’ve likely come across the term ‘dollar-cost averaging’ when browsing for sound investment strategies – or you may already be investing. Still, you’ve decided to switch up your strategy to see if you can improve your results.
Whatever the case, we’ve gathered everything you need to know about dollar cost averaging and how it works as an investment strategy.
What are the rules of the dollar-cost averaging investment strategy?
Instead of investing a lump sum into a particular stock or fund at one time, dollar-cost averaging works on the basis that you invest smaller, equal amounts at regular intervals over a set period of time – such as 6 or 12 months – usually weekly or, more often, monthly.
The strategy works on the assumption that, over the long term, the price of investments will increase on average. For this reason, dollar-cost averaging doesn’t typically work over a short period, as over just a few weeks or months, the price of shares fluctuates, enduring both rises and falls. Stock prices are unlikely to show growth in the same way they would over a more extended period.
So, if you want to invest $6,000 using the dollar-cost averaging investment technique, instead of investing all of the money at once, you would divide this sum up into equal amounts based on the length of time you want to invest in the stock or fund.
For example, you could invest $250 weekly or $1000 monthly over six months or $500 a month over 12 months.
The price of shares will vary month on month. Sometimes the price of shares will be high – where an investor will receive a smaller number of shares for their money – and sometimes, the costs will be low, where they’ll receive more shares for the same price.
Regardless of the price, however, investors using the dollar-cost averaging strategy will invest at the same time each month (or at whichever predetermined intervals are chosen before investing).
Overall, as the price increases for the individual share over a period of time, the number of shares owned should be equivalent to a greater value than was invested over that period, growing investors’ wealth.
But what are the benefits of using this strategy?
There are countless potential benefits to using the dollar-cost averaging investment strategy.
For one, spreading your investments out over time minimises the financial risk that you expose yourself. When you invest one lump some into a particular stock, there’s a possibility that the price of the stock will plummet, making your shares less valuable than the price you paid for them, resulting in a financial loss.
However, when dollar-cost averaging, you invest in the same stock or fund on multiple occasions over time. So, you may lose money on one investment. Still, you also have many other opportunities to buy shares at a more lucrative time and offset the unfortunately timed investment, allowing your money to grow overall.
Another significant benefit of cost-dollar averaging is that it doesn’t require the same volume of research that other investing strategies do, such as predicting when the stock market will rise and fall and purchasing shares accordingly.
This requires an in-depth knowledge of the economy and different sectors and businesses, and ensuring you keep this knowledge up to date – and even armed with this information; seasoned investors often find it difficult to predict the best time to invest accurately.
In contrast, aside from doing some initial research into the particular stock or fund, you’re investing in, the dollar-cost averaging mechanism negates the need for research past this point, as you invest at the same at regular intervals regardless of the price of shares at those particular times.
Dollar-cost averaging makes a smaller demand on your time than other forms of investing. It makes it a good choice for those just starting to get into the investment world for those who probably don’t have the know-how to ensure sound investment decisions via other more research-intensive methods.
Dollar-cost averaging is also suitable for more than just beginners – and for those who don’t want to spend lots of time researching. It’s also an excellent investment method for those who don’t have a lot of savings, as it spreads out the cost of investment over several months, allowing investors to take advantage of long-term market growth from the outset without first saving a significant sum of money.
So, if you’re looking for a less time-intensive, typically less risky method to begin investing, then dollar-cost averaging is one of the best options you can choose to help you grow your wealth.