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The stock market gets a lot of attention, especially these days when it’s been on a mostly upward run.
When it's on the upswing, some people may feel they are missing out, especially if interest rates on regular savings accounts are relatively low. On the other hand, there are down days — sometimes lots of them. The stock market does involve risk and there’s no guarantee that money invested in it will grow.
Indeed, an investment could disappear. So how can people strike a balance?
What is dollar-cost averaging?
Some turn to the long-term strategy that’s commonly called “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 of dollar-cost average investing. 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 would have only paid an average price of $27.69.
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. (Related: Winning with a steady strategy)
If you contribute a set amount to a workplace retirement plan each pay period, you're already using a form of dollar-cost averaging. (Learn more: 401(k) basics)
Who should use dollar-cost averaging?
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. (Related: Handling that stock award)
“By setting up a disciplined schedule of investments that you make regardless of market fluctuations, dollar-cost averaging can remove some of the emotion from investing and might help you avoid making impulsive decisions,” said the Financial Industry Regulatory Authority in its examination of the practice. “And by investing gradually as opposed to using all your investment funds at once, dollar-cost averaging can help you limit your losses in the event of significant market declines.”
Of course, transaction fees add to the cost of investing and offset returns somewhat, especially if there are numerous transactions. Also, over long stretches, investing a lump sum all at once has historically produced higher returns on average — dollar-cost averaging's advantage is mainly in reducing short-term downside risk and the temptation to time the market.
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. (Learn more: Life insurance, annuity alternatives in investing)
The first step for any investor, though, is understanding the risk they are willing to accept … and doing the math.
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Frequently Asked Questions about dollar-cost averaging
Q. Does dollar-cost averaging guarantee a profit?
A. No. Dollar-cost averaging lowers your average purchase price per share, but it doesn't eliminate risk or guarantee gains — you can still lose money if the investment declines.
Q. Is dollar-cost averaging better than investing a lump sum all at once?
A. Not necessarily. Over long periods, lump-sum investing has historically produced higher returns on average, but dollar-cost averaging can reduce short-term downside risk and take emotion out of the decision.
Q. Who is dollar-cost averaging best suited for?
A. It can appeal to investors who receive money in periodic lump sums — like an annual bonus — and want to ease into the market, or anyone who wants to reduce the temptation to time the market.
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