What’s Dollar-Cost Averaging?
If you were to receive a large inheritance one day and decide to invest that money in the stock market, would you dump that amount in one go or would it make more sense to break the chunk up into smaller amounts and invest a certain amount regularly over time?
By investing in regular intervals, you can avoid the risk of investing all of your money at a high or low point in the market, considering that no one can time the market.
This is known as dollar-cost averaging. Dollar-cost averaging is when you divide your total investment amount into equal parts and invest it at regular intervals rather than investing it all at once.
What’s in it for me?
Dollar cost averaging has multiple benefits as opposed to lump-sum investments. It can help you:
Reduce the impact of fluctuations in the market
This approach can help reduce the impact of volatility on your investments, as you are not investing all of your money at one time when the market may be at a high or low point. By investing in this way, you are essentially “averaging out” the cost of your investments over time.
Avoid emotional investing decisions
When you dollar-cost average, you’re guaranteeing that you’re investing regular amounts of money on regular periods, therefore, avoiding any emotional decisions like selling all your shares when the price of a stock hits a very low price or vice versa.
Huh? Let’s take some examples
Imagine you have $ 1000 to invest, and you want to invest it in a stock that is currently priced at $10 per share. Below are two scenarios for this situation to further understand dollar cost averaging:
Scenario 1: Lump Sum Purchase
If you invest the entire $1000 all at once with the current price of the stock, you will end up with 100 shares. This is called a lump-sum purchase.
Total Investment Value / Share Price = Number of shares purchases
$1000 / $10 per share = 100 shares
Scenario 2: Using dollar cost averaging:
The following scenario uses dollar cost averaging in a fluctuating market.
|Investment amount||Price per share||# shares purchased|
|Total||$1000||Average: $9.8||102 shares|
In this scenario where prices are falling, dollar-cost averaging allows you to benefit from this fluctuation in price so you were able to purchase 102 shares instead of a 100 shares in a lump sum scenario and with an average price/share of $98.75 instead of $100 in the lump-sum scenario so dollar cost averaging allowed you to buy more shares with less money than the lump sum scenario.
Is Dollar-Cost Averaging the right decision for me?
Dollar-cost averaging can be a good strategy for those who are new to investing and may
not be comfortable with the idea of investing a large sum of money all at once.
It can also be a good strategy for those investing for the long term, as it allows them to take advantage of fluctuations in the market over time.
It’s important to note that dollar-cost averaging does not guarantee a profit or protection against losses and it can potentially cause you to lose a chance at purchasing low-priced stocks in periods of increased prices. However, It is simply a way to manage and reduce risk and potentially smooth out the impact of market fluctuations and emotional decisions on your investments.