What is Dollar Cost Averaging, and how does it work?
- In the financial world, dollar cost averaging refers to systematically saving a specific amount into an investment.
- An example would be to transfer $100 a month from your checking account into an investment such as a mutual fund at the same time every month.
- If you can systematically invest in an investment that fluctuates in value, you buy your asset when your money is received.
Most public investment prices, such as stocks and bonds, are based on supply and demand for that security. The cost of those securities will bounce around throughout the day while the exchange matches the orders to sell and buy.
By systematically accumulating shares each month with your investment, you will collect more when the market dips, and it is like buying something "on sale." If you buy something at $10 a share and the price drops to $5 for a month, you will buy twice as many shares due to the price dip.
Price fluctuation is what makes dollar-cost averaging so effective over time. Think of it as buying something you will need for the future. And if you can buy it at a discount, even better, your investment will go farther when the price dips.
It's human nature to want to let your investments ride in a bull market, and it isn't easy to put assets to work after a significant pullback. Dollar-cost averaging is an excellent solution to trying to perfectly time when to enter or exit the market.
There is a famous statement, "It's time in the market, not timing the market that produces wealth." As a Spokane financial advisor, I have yet to see a client "time" an exit or entry to the market as their golden ticket. However, I have seen many clients succeed by systematically, incrementally building towards their goals by dollar-cost averaging. It may not be exciting in the short term but is sure to be worth it in the long term.
How to Start Dollar Cost Averaging
- Participate in your employer's retirement plan. Your employer will deduct funds from your paycheck and send them to your retirement account. Your employer may have a match they will send in with your contributions which will help you accumulate funds faster and the best way to give yourself a raise.
- Set up a Roth IRA if you qualify and transfer funds monthly. You can contribute for 2021, $6,000 a year if you are under age 50, and $7,000 if you are older than age 50 if you qualify.
- Set up an investment program through your financial advisor or a mutual fund company directly. It's easy, efficient, and chances are you won't even miss those funds.
- Buy some stock of your favorite stock that pays dividends and sign up for a "DRIP." A dividend reinvestment plan, which allows investors to reinvest their cash dividend into additional shares of the underlying stock on the dividend payment date.
Technology has made it easier to invest with small amounts, but you will not benefit from dollar-cost averaging if you don't take action. Ultimately, you are worth it.
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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.