Understanding dollar-cost averaging

By Allen Wastler
Allen Wastler is a former financial journalist with over 30-years of experience, including time at CNBC, CNN, and Knight-Ridder Newspapers.
Posted on Dec 19, 2017

The stock market gets a lot of attention, especially these days when it’s been on a record-setting run.

Some people may feel they are missing out, especially with interest rates on regular savings accounts so low. On the other hand, just a decade ago, the headlines surrounding the stock market weren’t all that sanguine. The stock market does involve risk and there’s no guarantee that money invested in it will grow. Indeed, the investment could disappear.

How do people strike a balance?

Some turn to “dollar-cost averaging.” That’s where investors purchase stocks at regular intervals in fixed dollar amounts. The math behind this practice reduces the average purchase price of the stocks in the portfolio, regardless of which direction the market is moving. That’s because as the price of a particular stock rises, fewer units are bought. And if the price goes down, the reverse is true.

Let’s take a hypothetical example. Say an investor wants to put $120 into a particular company’s stock each month. If the stock cost $30 per share the first month, the investor would get four shares. If the price drops to $20 the next month, the investor gets six shares. If, in the third month, the stock price rises to $40, the investor gets three shares.

After three months, then, the investor would have 13 shares, but only would have only paid an average price of roughly $27.

In short, with dollar-cost averaging, more shares are purchased when the price is low, and fewer are bought when the price is high, so the average purchase price per share is lower than the average share price. It’s important to note the dollar-cost averaging practice doesn’t eliminate risk. But the cost for taking on the risk is lower by lowering the average purchase price.

Some investors who get large sums of money periodically, say an annual executive bonus, use dollar-cost averaging to ease their money into the market, rather than investing the lump sum all at once. The practice would limit their loss in the case of a sudden market downturn. On the other hand, they would miss benefiting from a full gain should the market suddenly spike.

“If you’re looking to reduce your risk and control your emotions, or you fear that the market is heading for a drop, then dollar-cost averaging could be a viable strategy – even if that means forfeiting some potential upside,” said the Financial Industry Regulatory Authority in its examination of the practice. “You might consider how you would feel if you invested all of your bonus at one time and the market swooned soon after.”

Indeed, the risk is there. That’s why many investors often avoid or supplement investments in individual stocks by diversifying their portfolio to include mutual funds, bonds…and, yes, insurance.

The first step for any investor, though, is understanding the risk they are willing to accept … and doing the math.

More from MassMutual...

Mutual fund and ETF basics

Tax advantages of life insurance

Need advice? Contact us

________________________________

 

The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own, and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.