Dollar cost averaging is a strategy to buy stocks over time; at a consistent time interval (maybe every paycheck, or every month) you purchase a fixed dollar amount of stock. It's like stacking bricks. One brick at a time, and before you know it, you've built a wall.
The thinking is that by purchasing at various times, sometimes the stock price is higher and others lower. When it's higher, you buy slightly fewer shares, when it's lower you get slightly more. The math works out that your average price benefits from this strategy by being slightly lower because the extra shares you get when the price is lower weighs down the average.
That's a lot of math. Let's dig in a little to some of the benefits of dollar cost averaging, because I think there are mostly benefits to this strategy.
Why dollar cost average?
Well, in truth, most of us are investing out of our paycheck and take a small amount and put it away to invest. It's much more common to do that than, say, to have a windfall come your way (like an inheritance, or even a bonus at work) that you have to invest.
So, dollar cost averaging is really what we'd naturally do as we start to build wealth. Take a little bit of money out of our paychecks and invest it in the market, consistently over time. Dollar cost averaging ends up being more of an explanation of what will happen than an explicit strategy.
dollar cost averaging ends up being more of an explanation of what will happen than an explicit strategy
By dollar cost averaging... meaning, by buying automatically with a given amount at fixed intervals you are supporting your efforts to not attempt to time the market. Timing the market is for professionals and fools. Not for individual investors.
Where to use dollar cost averaging
Well, you might not realize it, but if you're investing in your company's 401(k) or systematically putting money into an IRA, you're dollar cost averaging.
It can also be used outside of retirement plans. Like with Stockpile or Fidelity. As long as you can buy regularly without paying a commission, you can invest small amounts and keep the habit going.
Watch out for fees and commissions
The challenge with paying a commission when you're investing small amounts is that the commission becomes a high percentage of the overall investment (and is counted against your cost). Take an extreme case – you invest $10 every paycheck, but you have a $10 commission. That double's the cost of the stock you're buying. If the stock you're buying is $10/share... you're paying $20.
With Stockpile, as an example, you do pay a $5/month fee (or less if you pay for longer terms than monthly up front), so it becomes "easy" to invest small amounts with each paycheck and not have those investments overwhelmed by the account fees.
Benefits of dollar cost averaging
- Dollar cost averaging can lower the cost of your investments
- It reinforces the practice of investing regularly to build wealth
- If you make it automatic, you take the decision out of your hands and avoid the urge to try to time the markets
- If you're investing for dividends, like I enjoy, each time you invest, you're getting a raise. And, raises are fun!
If you've read this far, and want another good article on dollar cost averaging, read this one on Modest Money.
