The Advantages and Disadvantages of Dollar Cost Average | Smart Change: Personal Finance

(FINRA staff)

When thinking about investing, one consideration is whether you want to invest money all at once or over a period of time. If you choose the latter route, you may be opting for an investment strategy called dollar cost averaging.

Averaging the dollar cost, you invest your money in equal parts, at regular intervals, regardless of the ups and downs in the market.

Let’s say you receive a bonus or have $10,000 saved to invest. Instead of investing that amount all at once, averaging the dollar costs allows you to split that $10,000 into 10 parts and invest $1,000 per month for 10 months.

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You may already be doing dollar cost averaging and not even know it. If you have a 401(k) or other type of defined contribution plan, your contributions are allocated to one or more investment options on a regular, fixed schedule, regardless of what the market does. Each time this happens, calculate the dollar cost average.

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Before you start splitting your money, here are three things to know about dollar cost averages:

Why should anyone consider the dollar cost average?

It would be great if we could buy stocks or other types of investments when the market is low and sell when the market is high. Unfortunately, attempts to “time the market” often backfire, and investors end up buying and selling at the wrong time.

When stocks fall, people often get scared and sell. Then, if the market moves back up, they may be missing out on potential profits. On the other hand, when the stock market rises, investors may be tempted to rush in. But they may eventually buy when the stock is about to fall.

Averaging the dollar cost can help take the emotion out of investing. It forces you to keep investing the same (or roughly the same) amount regardless of market fluctuations, potentially resisting the temptation to time the market.

If you cost dollars on average, you will buy more shares of an investment when the stock price is low and fewer shares when the stock price is high. This can lead to you paying a lower average price per share over time.

And by getting in, rather than transferring your money all at once, dollar cost averaging can help you cut your losses in the event that the market falls.

What are the potential downsides of dollar cost averaging?

Averaging the dollar cost can be a useful tool in reducing risk. But investors who participate in this investment strategy can potentially lose higher returns. Averaging the dollar cost, you hold onto your money longer than cash, which carries lower risk but often yields lower returns than lump sum investing, especially over longer periods of time.

If the market is rising during a period when you are averaging dollar costs, you may be missing out on the potential gains you could have had if you invested right away in one fell swoop.

Of course, this doesn’t apply to something like your 401(k), because in that situation you’re investing the money as you earn it, and only holding cash at a later date.

Also, keep in mind that if you’re dealing with dollar cost averaging, you may run into more brokerage fees. These costs can affect your return. And you also have to be disciplined with that money that is on the sidelines to eventually invest it and not erode it with purchases.

What is the bottom line for investors?

As is the case with all aspects of investing, it is important to consider potential returns and your tolerance for risk.

Investing all your money right away can give you a higher return than trickling out smaller amounts over time.

But if you’re looking to reduce your risk and control your emotions, or if you’re concerned about volatile market conditions, dollar cost averaging can be a viable strategy, even if it means losing a potential advantage. If your main concern is reducing short-term downside risk and avoiding regrets after a potential loss, calculating the dollar cost may be right for you.

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