Dollar-cost averaging is a tactic utilized by investors whereby they invest the same fixed dollar amount over regular intervals, such as each month or quarter. While the amount of money invested each month remains the same, the number of shares it buys will vary based on fluctuating prices. When prices are higher, the investor buys fewer shares; when prices drop, that fixed amount buys more shares.
This is fundamentally what happens when workers defer money from their paychecks into a 401(k) plan each month. Not only can dollar-cost averaging help manage short-term risk, it is a disciplined strategy that can yield positive long-term performance as well.
With the possible exception of a prolonged declining market, regular investing enables an investor’s account balance to rise even when there is a slight performance decline, simply because money is added regularly.
The key is to save consistently, even during a down market. That’s because shares purchased at the lowest prices are positioned for the greatest gains. Generally speaking, investors who possess the fortitude to continue investing through market corrections are more likely to achieve long-term success.
Dollar-cost averaging also offers the potential to pay a lower cost for shares. By investing the same amount regularly, an investor buys fewer shares at a higher price and more shares at a lower price. On average, the cost of each share will be lower than the average price. Here’s an example of how this might work over a six-month period:
Total invested: $6,000
Total shares purchased: 367.7
Average price per share: $105 (total of monthly share prices) 6 (months) = $17.50
Average cost per share: $6,000 (total cost) 367.7 (total shares) = $16.31
As you can see, over the six-month period, the actual average cost of the shares was lower ($16.31) than the average price paid per share ($17.50).
However, lower cost per share is achieved only if other expenses are minimized. For example, dollar-cost averaging into a mutual fund is not likely to trigger ongoing transaction fees. However, some mutual funds have a high expense ratio, which can reduce long-term returns. On the other hand, if an investor was to buy shares systematically in a stock portfolio, trading fees may offset some of the cost advantages of dollar-cost averaging.
Dollar-cost averaging reduces the risk of investing a lump sum of money when prices may be inflated, at which point the investment would steadily lose money when prices normalize. The tactic eliminates the need to study the momentum swings associated with the market timing and the folly of committing to a one-time purchase on the cusp of a significant market downturn.
The following example demonstrates how dollar-cost averaging can outperform a lump-sum investment of $100,000 by spreading out the investment over four consecutive weeks.
Lump sum share price: $147.24
DCA average share cost: $145.78 ($100,00 685.92 total shares)
As you can see, the share price dropped during the four-week investment period, enabling the investor to purchase more shares than he would have acquired with a lump-sum investment. In this scenario, not only did the DCA tactic command a lower average cost per share, but the investor avoided a loss during the price decline and actually increased his market value despite the volatility in share prices.2
These scenarios by no means guarantee that dollar-cost averaging will deliver better returns than lump-sum investments, nor will the tactic protect investors from risks associated with volatile and declining markets. In fact, because the market has historically proven to rise two-thirds of the time, there is a greater probability that an investor will pay a higher average price than he might with a one-time investment.3
However, the benefit of dollar-cost averaging lies in its consistency and the risk of investing during a market upswing. The thing about a market upswing is that we never know when we’re in one, because the very next day prices can rise higher or begin to decline.
“For investors with a large cash balance on hand, the stakes are high. Out of worry that an investment will quickly lose value, they may gradually ease into the market. Such an approach can minimize feelings of regret by providing short-term, downside protection against a rapid decline in a portfolio’s value.”4
Dollar-cost averaging has its advantages and disadvantages. One of its biggest benefits is more psychological than strategic: An investor needn’t worry about dramatic market movements. Regular fixed-amount investing helps smooth the fluctuations of daily market volatility and can provide an average lower cost per share over time. Because of this, stock price variances are foreseen and managed, rather than feared.
While it is an inherent tactic used with deferred income contributed to employer-sponsored retirement plans, DCA also may be appropriate for periodic windfalls, such as inheritances.
Finally, consider dollar-cost averaging one of many different tools that can be used to manage an investor’s overall portfolio, along with diversification, asset allocation and periodic rebalancing.
1 Brian Bloch. Investopedia. “Fight the Good Dollar-Cost Averaging Fight.” https://www.investopedia.com/articles/stocks/07/dca-fight.asp#ixzz56RqWcZx3.” Accessed Feb. 7, 2018. 2 Emmanuel Marot. Seeking Alpha. May 1, 2017. “Dollar-Cost Averaging: Does It Work?” https://seekingalpha.com/article/4067554-dollar-cost-averaging-work. Accessed Feb. 7, 2018. 3 Russell Wayne. Investopedia. April 17, 2017. “Why Dollar-Cost Averaging Is a Good Idea.” https://www.investopedia.com/advisor-network/articles/why-dollarcost-averaging-good-idea/. Accessed Feb. 7, 2018. 4 Siena Investments. May 3, 2017. “Invest Now or Temporarily Hold Your Cash?” https://www.sienainvestor.com/siena-investor-blog/invest-now-temporarily-hold-cash. Accessed Feb. 16, 2018. Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC. The advisory firm providing you this report is an independent financial services firm helping individuals create retirement strategies using a variety of investment and insurance products to custom suit their needs and objectives and is not an affiliate company of AE Wealth Management, LLC. Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. The information and opinions contained herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by AE Wealth Management. This information is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual’s situation. None of the information contained herein shall constitute an offer to sell or solicit any offer to buy a security or insurance product. AE WEALTH MANAGEMENT
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