What is Dollar Cost Averaging?
“Cameron, I want to contribute to my Roth IRA/brokerage account/529 plan/other investment account. Is it better to put a lump sum of money in all at once or to deposit a little bit at a time?”
Translation: Should I dollar-cost average?
Dollar-cost averaging is based on the principle that the market is volatile and unpredictable. It moves up and down with little prediction and no heed for human wishes. Most observers fear declines for a drop in value. However, dollar-cost averaging tries to take advantage of the volatility. Here’s how:
If you decided to buy the same pair of shoes on the first day of every month for a year, it would be weird, but you would get the shoes for different prices each month. Some months, you would have to buy the shoes at full price. Other months, there would be various sales that would decrease the cost of the shoes that month. However, if you averaged out the price of all 12 pairs at the end of the year, the average cost would be less than the full price of the shoes. Even though some months you paid that full price, the lower-cost months would drop the overall average.
Compare this to picking one month out of the year to buy all 12 pairs of shoes. Some of those months, you would pay full price for all of the shoes, and the average value would be full price. Some months, you may get the sale, and the average price winds up lower than full price. That said, this approach is predicated on the fact that you have to gamble on which month may have a sale. Pick the wrong month, and you’re paying a higher average price for your shoes.
Let’s trade out the shoe example for the stock market. If you make periodic investments in an account and the market goes down, you’re buying at a discount. In fact, you’re actually getting more shares for the same investment price. If the market goes up the next month and you purchase shares, your average cost per all share is lower than if you had bought everything this month, just like the shoes.
Over time, the average cost per share by buying a little bit every month is less than if you bought it all at one time. This is dollar-cost averaging. For many clients and many types of client accounts, this approach makes the most sense and helps them take advantage of a volatile stock market.
Are you interested in dollar-cost averaging a new account? Whether you’re looking for a financial advisor for nurses, a financial advisor for families, or a financial advisor for retirement, a complimentary, no-obligation meeting is easily available to you.
Dollar-Cost Averaging does not assure a profit and does not protect against loss in declining markets. Also, since such a program involves regular investment purchases regardless of fluctuating price levels of the investment, consider your financial ability to continue purchases through periods of low price levels.