How does cost averaging work

If there was a magical formula for picking the right day each month to buy stocks, we'd all just buy then and not have to figure out other strategies.

However, when you dollar-cost average is important. Specifically, you must make a consistent plan and stick to it. A lot of the benefit of the strategy is that, by breaking the investment into chunks, you can avoid worry over when to buy in and avoid trying to time the market.

Therefore, it's important that, once you pick a date, you stick to it no matter what happens. But, in month four, you notice that stocks have been up the whole week leading up to the first day of the month. It might be tempting to assume that a sell-off is inevitable any day, so you hold off buying on the first day of the month in the hope of getting a better price in the days that follow.

If you do that, you eliminate a lot of the rationale behind trying dollar-cost averaging. There are a few things to consider before dollar-cost averaging. For one, it's impossible to predict whether stock prices will go up or down on any particular day, week, or even year. But there is a century's worth of data showing us that markets do rise over time. If you park most of your money out of the market and only buy in a bit at a time, you avoid short-term volatility.

But that also means a portion of your cash is on the sidelines and not working to build your net worth. That's a particularly big risk if you are focused on dividend stocks and other income-generating investments.

Except in extreme cases, dividend payers continue distributions in good markets and bad. If you use dollar-cost averaging to slowly build a position in a dividend stock, you miss out on getting dividends on the portion of your cash you haven't yet invested. Finally, note that any investment strategy is only as good as the stocks you pick. Dollar-cost averaging can help ease apprehension and is better than trying to time the markets, but it is no substitute for finding quality companies to invest in.

Dollar-cost averaging is beneficial because it can reduce investor anxiety, help avoid trying to time the market, and can provide a predictable, regimented way to continuously grow your nest egg. If that's of interest to you, there are a few simple steps to follow:. There is no one right way to invest. But if you're an investor looking to increase your net worth but worried you might be tempted to time the market, or you're dedicated to adding a little bit each month regardless of recent stock returns, dollar-cost averaging can be an effective way to build your portfolio.

Discounted offers are only available to new members. Stock Advisor will renew at the then current list price. Investing Best Accounts. Stock Market Basics. This sounds easy enough, in theory. And trying to time the market can really cost you. According to research by Charles Schwab, investors who tried to time the market saw drastically less gains than those who regularly invested with dollar cost averaging.

Dollar cost averaging takes the emotion out of investing by having you purchase the same small amount of an asset regularly. This means you buy fewer shares when prices are high and more when prices are low.

Consider this hypothetical month result:. In this example, dollar cost averaging buys you more shares at a lower price per share. From a practical standpoint, dollar cost averaging helps you begin investing with small amounts of money. You may not, for example, have a large sum to invest all at once. Dollar cost averaging gets smaller amounts of your money into the market regularly.

For some people, maintaining investments during market dips can be intimidating. However, if you stop investing or withdraw your existing investments in down markets, you risk missing out on future growth. Those who remain invested during bear markets , for instance, historically have seen better returns than those who withdraw their money and then try to time a market return, according to Charles Schwab research.

In fact, research from the Financial Planning Association and Vanguard has found that over the very long term, dollar cost averaging can underperform lump sum investing. You may not have a large amount of money saved up—and waiting may cause you to miss out on potential gains. It can be stressful to invest a lot of money at once, and it may be easier psychologically for you to invest portions of a large sum over time.

In addition, dollar cost averaging still helps your money grow. Also, keep in mind that lump sum investing only beat dollar cost averaging most of the time. A third of the time, dollar cost averaging outperformed lump sum investing. As a long-term investment strategy, dollar cost averaging keeps you in the market and makes you buy shares even when the market is down.

Because dollar cost averaging takes the emotion out of purchasing decisions, especially in down markets, it helps you position yourself and your investments for success over years and decades. With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree. Select Region. United States. For most of us, each month, our employers make contributions for out benefit to superannuation.

The decision to actively choose to implement a dollar cost averaging strategy arises for investors who need to restructure investments to manage a new stage of life or perhaps due to an abnormal receipt of funds such as an inheritance. The success of a dollar cost averaging strategy will depend upon the future returns from the investment.

Let's look at a simple example of dollar cost averaging in action. Dollar cost averaging helps reduce the risk that the timing of a purchase coincides with the price being particularly high. The table also shows the best and worst cases achieved if the total purchase was made all at one time instead of being spread out:. In summary, a dollar cost averaging strategy can be an effective way to invest over the long term, however, there are market environments which would better suit lump sum investing.

For a long term investor, the decision should be about time in the market not timing the market. Perhaps the decision to invest a lump sum over a longer period of time should be based on your appetite for risk. If you can tolerate short term price volatility in favour of longer term gains, you may consider making lump sum investments during low entry points.

Many investors, however, remain cautious on short term price volatility regardless of the long term investment horizon and gain more comfort from slowly deploying funds into the market to average out the entry point. The secret to successful investing is time in the market, rather than timing the market. Superannuation Super explained How much super is enough?

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