Monday, February 17, 2014

Dollar Cost Averaging: Investment Strategy For Newbies

I thought this was a really cool variation of a calendar.

Read this if: 

1) You want to start investing but you don’t know how much money to invest. 
2) You don’t know how often to put money into your investments. 

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When I first started looking into investments, one of my biggest concerns was how much to invest. I was told about the concept of “dollar cost averaging,” which I will explain here. I think it's very useful for anyone who is just starting to invest, and is especially good for long term investing (which is what I encourage people to do). 

What is it, and how does it work? 

If someone says, “I invest X amount of dollars every month,” then they are using the dollar-cost averaging strategy. For example, I invest fifty dollars every month. The time increment is up to you (two weeks, four weeks, two months, etc.) but the key is to do it regularly, in constant amounts. 

Let’s say you invest every month, but you invest $40 in September, $20 in October, and $30 in November. That is NOT dollar-cost averaging because the amount you invest is not the same. 

Why does it work? 

In layman’s terms: you buy shares no matter what the price is. That means when you invest the same amount of money, you buy more shares when prices are low (which is good) and less shares when prices are high. As we know, prices of shares tend to fluctuate and while some people watch the market for good times to buy (i.e., when prices are low), a lot of people don’t (and really don't want to think about timing their investments). 

Another reason this is a good strategy is because (ideally) you won’t know or care if prices rise or drop suddenly. Some people get really upset when they see their investments start to fall and sell immediately to protect their money. I can’t speak for every situation, and there are always exceptions, but the stock market tends to recover over time. It’s better to just leave your investments be, and know that it’ll be ok one day in the future. 

(Note: This isn't so much a financial reason as it is a psychological one, but I do feel much more secure investing little chunks of my money at a time, instead of putting all $5,000,000,000 into a stock at once.)

What are the downsides?

There are lengthy articles written about why dollar-cost averaging is not the BEST investment strategy. For example, in some situations, you'd earn a lot more if you had just invested all your money at once, so you'd lose out if you invested using the dollar-cost averaging strategy. 

Also, let's say that you're investing $50 in a stock every month, and you have to pay $7.99 as a commission every time you buy shares. That's 16% of your money gone! If your stock does really well, then the fees won't matter that much, but until then, it's still kind of heartbreaking to lose such a large portion to fees. 

Bottom Line


It's simple and easy and many experts agree that it is an effective investment strategy. This article does a great job of explaining the pros and cons, using lots of numbers that you should check out for more info! 

(P.S. "Dollar cost averaging" sounds really fancy, so toss that term around and impress people.) 

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As always, contact me with questions or suggestions! 

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Photo Credit: eliazar via photopin cc

2 comments:

  1. One painless, almost invisible, way to dollar cost average is to sign up for a dividend reinvestment plan with your stocks or stock mutual funds. When you do this, any dividends you receive on your investment will automatically be used to purchase more shares.

    Obviously, this strategy applies only to investment vehicles that pay dividends. Historically, dividends have, I believe, represented about half of the total returns that stock ownership has offered. I believe it is an excellent way for a young person to build a portfolio.

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  2. Thanks for the advice! I'll be sure to highlight this for readers!

    ReplyDelete