The power of dollar cost averaging

The power of dollar cost averaging

Buy low, sell high. That is the key to investment success, isn’t it? The only problem with that advice is that it’s nearly impossible to predict what the stock market is going to do in the immediate future. The stock market can be fairly predictable over long periods of time, but it can be irrational and volatile in shorter periods. How do you know if something is priced low if you don’t know whether it’s going to move higher or lower?

While there’s no way to predict the future, there is one investment method that helps manage the market’s volatility. Dollar-cost averaging is an investment method that mitigates volatility by purchasing more shares of an investment when it’s priced low, and fewer shares when the stock is priced high.

How it works.

You start the dollar-cost averaging process by selecting a dollar amount that you’d like to invest on a regular basis. The investment could be made weekly or even monthly. At each interval, you’ll make your predetermined investment. If the investment’s price is high, your amount will buy fewer units. If it’s lower, your investment amount will buy more units.

For example, assume that you’d like to invest $100 every month into a particular company’s stock. In month one, the stock price is $25 per share, so your $100 investment buys four shares. In month two, the stock’s price dropped to $20 per share. Now your investment buys five shares. You have now paid $200 for nine shares of stock for an average price of $22.22 per share

Had you simply bought five shares each month, you would have paid $225 for 10 shares for an average price per share of $22.50. By fixing the dollar amount rather than the share amount, you buy more shares when the price is low and less when the price is high.

The difference in average share price in the example above may seem like only pennies. However, consider the effect on thousands of dollars a month and over many years. Dollar-cost averaging could significantly reduce your average share price, which will increase your gain when you eventually sell the investment.

Dollar-cost averaging is also powerful because it helps reinforce saving. Most dollar-cost averaging plans are done automatically electronically. By committing to an automatic plan, you can set yourself up for success with a regular and consistent savings plan.