The Benefits and Limitations of Dollar-Cost Averaging
One consideration when investing is whether to put your available funds to work all at once or over a period of time. If you choose the latter route, you might opt for an investment strategy called dollar-cost averaging.
With dollar-cost averaging, you invest your money in equal portions, at regular intervals, regardless of current market conditions.
Assume you have a pool of money to invest—say $10,000—perhaps from savings, a bonus or an inheritance. Instead of investing all of that money at once, you might invest $1,000 a month for 10 months with dollar-cost averaging. In the meantime, you might hold the balance in a low-risk, easily accessible account so it’s ready for future withdrawals according to your schedule.
If you’re currently investing in a 401(k) or other type of employer-sponsored defined contribution plan, you’re likely already engaging in dollar-cost averaging. The contributions to your plan from each paycheck are allocated to one or more investment options on a regular, fixed schedule regardless of what the market is doing. This is an example of dollar-cost averaging.
Before choosing this strategy for your other investments, here are some factors to consider.
Potential Benefits of Dollar-Cost Averaging
Some investors get fearful and sell when markets go down, potentially missing out on gains when the market goes back up. Or they might be tempted to rush in when markets go up, possibly then ending up buying just before prices drop. By setting up a disciplined schedule of investments that you make regardless of market fluctuations, dollar-cost averaging can remove some of the emotion from investing and might help you avoid making impulsive decisions.
Since you invest roughly the same amount of money at each interval, dollar-cost averaging means you’ll buy more shares of an investment when the price is low and fewer shares when the price is high. This sometimes results in paying a lower average price per share over time.
And by investing gradually as opposed to using all your investment funds at once, dollar-cost averaging can help you limit your losses in the event of significant market declines. The money you had set aside and not yet invested would be unaffected by the drop.
Limitations of Dollar-Cost Averaging
While dollar-cost averaging can be a helpful tool in lowering risk, following this strategy can also potentially impact returns. Holding onto your money as cash longer and spreading out your investments gradually has lower risk but often produces lower returns than lump sum investing, especially over longer periods of time. The trade-off is that while dollar-cost averaging may reduce the impact of short-term market swings, you could also miss out on some gains since part of your money stays in cash instead of being invested right away.
This opportunity cost argument against dollar-cost averaging doesn’t apply when your funds are coming from a defined contribution plan since you’re investing the money as you earn it, not holding money in cash for future investment.
If you pay commissions or other fees for each transaction, dollar-cost averaging might result in higher fees than lump sum investing due to the greater number of transactions you’ll have, which could erode your returns. You’ll also want to be thoughtful about how you manage money that’s sitting on the sidelines as you implement a dollar-cost averaging strategy. Dipping into the funds you’ve put aside might impact your long-term financial plans.
As with all aspects of investing, it’s important to consider potential returns as well as your tolerance for risk and volatility. Consider working with an investment professional to help you determine the best investment strategy to achieve your individual financial goals.
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