How to Use Dollar Cost Averaging to Build Wealth
If you’ve talked to a financial advisor or read about investing online, the chances are that you’ve come across the phrase, “Time in the market beats timing the market.”
In other words, you’re more likely to be successful by regularly contributing to your investment accounts over long periods of time, rather than attempting to forecast market crashes and rallies. After all, even the best experts can’t predict when the next crash will happen.
And that brings us to dollar-cost averaging.
With this investment strategy, you don’t have to worry about whether stocks are too expensive to buy. Simultaneously, you also don’t have to worry whether you’re missing out on market gains.
Simply put, dollar-cost averaging is the exact opposite of attempting to time the markets.
Timing the markets, especially during stock market volatility, can result in panic buying (or panic selling) and irrational or even emotional decisions. By utilizing dollar-cost averaging, you are systematically investing in building wealth over the long-run. The ebbs and flows of today will no longer create the emotional dangers of overconfidence or panic.
[article post=”1″]So What Exactly Is Dollar-Cost Averaging?
This strategy involves buying a fixed dollar amount of investments at a regular interval.
If you already have a retirement account such as a 401(k) through work, then chances are that you’re already utilizing dollar-cost averaging. For example, 10% of your paycheck might be withheld every payday to be invested in your retirement accounts.
No matter what the markets are doing, there’s a fixed amount of your income used to purchase stocks, mutual funds, or other investment vehicles.
During economic turmoil, your money will be able to purchase more shares when prices are low. When bulls are running the stock market, however, your money will purchase fewer shares. Over time, these costs “average” out, usually resulting in far greater gains than if you had attempted to time the market.
What Are The Benefits of Dollar-Cost Averaging?
Dollar-cost averaging, which is also known as the constant collar plan, is powerful at building savings and wealth over a long time.
The advantages of this strategy include:
Generally reduced risk.
Let’s say you invested $300 in a lump sum. You could purchase mutual funds at $30 a share and therefore add ten shares to your portfolio. Ten shares is still better than 0 shares! But what would have happened if you invested $100 a month over three months instead?
[article post=”2″]Let’s say that the first month, the mutual fund shares were priced at $30. You would have been able to purchase three shares with a $100 monthly investment.
But let’s say the second month, the cost dropped to $15. With that same $100 monthly investment, you would be able to get six shares instead. And even if the market recovered to $25 per share in month three, you’d still be able to purchase four more shares.
In the first scenario, you were able to purchase ten shares of the mutual fund. Thanks to dollar-cost averaging in the second scenario, you could buy 12 shares of the same fund. This is over three months. Imagine repeating this same process over and over throughout the years and decades! The compounding impact is truly tremendous!
Getting started immediately.
For new investors, one of the misconceptions is that they have to save a lot of money to invest in the stock market. Fortunately, because dollar-cost averaging is a long-term play, you can begin investing immediately. Set aside a portion of each paycheck to contribute to your retirement or general investment accounts.
You don’t need thousands or hundreds to invest. Even $50 or $100 a month will add up and compound in the long-term.
Some people even find that when they start investing, they’re more likely to stick to their budget (or create a written budget). Allocating a specific amount of money each month towards investing means that you have to be smarter with the rest of your leftover money. What an excellent opportunity to get a better handle of your budget!
Peace of mind.
Trying to time the market is incredibly stressful. By fully leaning into dollar-cost averaging, you can breathe easier, even when the economy is going through tumultuous times. Even though past performance is no guarantee of future returns, we can assume that prices will, eventually, always rise.
On a similar note, this strategy removes (or reduces) the emotional component of investing. Sure, you might continue to watch the stock market ticker to see which way prices are swinging, but you will still stick to the present course of buying a specific dollar amount every interval. Instead of viewing market drops as a time to panic, these are now viewed as opportunities to acquire more shares at a favorable cost.
This strategy provides both mathematical and emotional benefits. But are there any disadvantages to dollar-cost-averaging?
The Challenges of Dollar-Cost Averaging
Like any other financial investment strategy, dollar-cost averaging does have a few downsides.
[article post=”3″]For example, it’s not a substitute for identifying good investment opportunities.
You must still do your research before investing in a stock, mutual fund, or any other investment vehicle. If you’re working with a financial advisor, make sure that you understand exactly what you’re investing in! Dollar-cost averaging is a healthy strategy, but a bad investment is a bad investment, no matter how regularly you invest into it.
Another trade-off is that you might get lower than expected returns. Remember, the largest benefit of dollar-cost averaging is that you’re eliminating large amounts of risk by investing in smaller chunks consistently over time. But, the adage of “the greater the risk, the greater the potential reward” still holds true.
Does this mean that you shouldn’t use dollar-cost averaging? Of course not! After all, higher risk does inherently mean there’s a higher chance of not receiving a return.
In short, if you’re in a financial position to take bigger risks, this might not be the most attractive strategy for you. But if you’re looking to build wealth over the long-run safely, then dollar-cost averaging is certainly an attractive candidate!
Tips to Make Dollar-Cost Averaging Work for You
If you have a job that offers retirement benefits such as a 401(k), then utilizing this strategy can be as simple as setting up regular contributions to your account. Most brokerage accounts allow you to set up automatic deposits at regular intervals. If you’re investing on your own, then make sure you set up your own purchase schedule, say, on the first of each month.
Another tip is to tell your brokerage to reinvest dividends automatically. This can add extra juice to the strategy by continuing to buy the stock or mutual fund and compound your gains over time.
Dollar-cost averaging is a slow, steady strategy that is reliable, but it does take time. It’s easy to get lured by the latest financial fads and get-rich-quick schemes. While some people had certainly made lots of money from these endeavors (say Bitcoin or buying in tech stocks before they exploded), those are generally the exceptions and not the rule.
It’s easy to imagine a scenario where lump sum investments into new opportunities can outperform the steady dollar-cost averaging strategy. But reality can strike hard.
Bottom Line
In short, the most important thing that you can do for you and your family, by far, is to save money and to invest for the long term. If this strategy helps you accomplish that with peace of mind, then definitely go for it!
And of course, always feel free to consult with a professional financial planner to determine the best approach for your unique situation.
