It has been argued that the best way to invest in the stock market is with a lump sum of capital that can be properly diversified across several asset classes. But, for many people with a desire to achieve long term growth, that is not possible because they’ve yet to accumulate a lump sum of capital. However, they may have the capacity to commit a portion of their monthly savings to growth investments. While they may be exposed, early on, to price fluctuations of the market, they can actually do very well over time with a committed and disciplined dollar cost averaging strategy. If you are currently contributing a part of your earnings to a qualified retirement plan, such as a 401(k) plan, you are already applying the strategy.
How Dollar Cost Averaging Works
Fundamental to the strategy is a commitment to investing a fixed amount each month, whether it’s $1000 or $2000. Depending on your investment objectives and risk profile, your funds can be invested in a mixed portfolio of mutual funds, exchange-traded funds, or even individual stocks (although that is not recommended in the early stages of the strategy). Each month, your fixed amount will buy a certain number of shares at the then current prices. As share prices decline, your fixed amount will be able to buy a higher number of shares; and when prices increase, fewer shares are purchased.
If the overall trend for stock prices is up, as it has been since the inception of the stock market, your average purchase price, or cost-basis, will always be less than the prevailing share price. Of course, it would be important to follow this strategy through at least a few market cycles (up and down markets) to realize the full value of dollar-cost averaging. You can, however, get a sense of how dollar-cost averaging will work in your favor in just a few short months.
Let’s say you decided to start investing after the stock market has reached new highs. If you start to invest $500 a month in a stock index fund priced at $20 a share, your initial investment will purchase 25 shares. If the stock index immediately declines in value to $15 a share, your next monthly investment would buy 33 shares. You will then own 58 shares with an average cost-basis of $17.17 per share. If the stock index climbs to new highs the next month, and the share price reaches $30 a share, you will add 16 shares for a total of 74 shares, and your average share price will be $20.27, almost $10 below the current share price.
The real value of dollar-cost averaging is that you don’t need to worry about investing at the top of the market or trying to determine when to get in or out of the market. As long as the stock market continues with its historical, upward trend, with periodic declines, the value of your portfolio will always be higher than your average cost-basis.
The key to its success is your ability to commit to a systematic process of setting aside a fixed dollar amount (that can be increased as your cash flow allows), and following a disciplined investment strategy that includes broad diversification across several stock market segments.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.