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What is dollar cost averaging?
Why Bother With Dollar Cost Averaging
Dollar cost averaging is an investing strategy where a consistent amount is invested at regular time intervals, regardless of the cost of the investment. If you have a 401k at work set to automatically put 5% of your income into a mutual fund, that’s dollar cost averaging.
This strategy, while not exciting, has proven to be successful, as it eliminates the possibility of most of the mental mistakes that an investor can make. It takes the emotions and unknowns out of the equation.
Over the long term, if you are investing in a quality mutual fund, index fund or even an individual stock, the daily ups and downs of the market generally do not matter much compared to the long term growth. What happens to almost everyone when they try to time the market by selling at the peaks and buying the dips is that they panic sell near the bottom or buy in euphoria at the peak. Money is an emotional topic, and it’s almost impossible to keep a level head when the market is rapidly moving.
If you have a thousand dollars a month to invest it on the first day of every month, regardless of the market, studies have shown, time after time, that over the long term that strategy tends to beat out those who try to time the market. Those mental mistakes that cause people to buy at the top and sell at the bottom are removed from the equation.
Another reason that dollar cost averaging is so effective is that it prevents another major mistake that some investors fall victim to. Very often conservative type investors never get started due to paralysis by analysis. Some are so fearful of losing money that they never get started.
While being conservative often pays off, you have to get started. If you are worried about losing money, remember your time horizon and commit to investing something every month. Even if it’s a small amount. This will prevent you from missing out. Most brokerages even allow you to set it up automatically, so you will not even need to worry about it.
Dollar cost averaging should be a part of everyone’s strategy. If you are conservative, it takes the fear out and gets you started. If you tend to be aggressive, it will prevent you from making a huge mistake that could wipe you out.
This does not mean you need to dollar cost averageall of your portfolio, many of us are reading this blog because we are trying to beat the market, but pick a mutual fund and commit part of your savings going into it every month regardless of the ups and downs of the market. Having something secure in your portfolio that you never need to worry about will take a lot of stress off, especially when a bear market comes. To the dollar cost averaged portfolio, a bear market is actually welcome, you will be able to buy more shares that month. You are literally buying at the bottom, which is what you are trying to do if you are an active trader anyway.
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