how dollar cost averaging works
dollar cost averaging is a simple tool that an investor can use to build savings and wealth over the long term it is also a way for an investor to ignore short term volatility in the broader markets a prime example of long term dollar cost averaging is its use in 401 k plans in which employees invest regularly regardless of the price of the investment with a 401 k plan employees can choose the amount they wish to contribute as well as those investments offered by the plan in which to invest then investments are made automatically every pay period depending on the markets employees might see a larger or smaller number securities added to their accounts 1dollar cost averaging can also be used outside of 401 k plans for instance investors can use it to make regular purchases of mutual or index funds whether in another tax advantaged account such as a traditional ira or a taxable brokerage account dollar cost averaging is one of the best strategies for beginning investors looking to trade etfs additionally many dividend reinvestment plans allow investors to dollar cost average by making purchases regularly benefits of dollar cost averagingwho should use dollar cost averaging the investment strategy of dollar cost averaging can be used by any investor who wants to take advantage of its benefits which include a potentially lower average cost automatic investing over regular intervals of time and a method that relieves them of the stress of having to make purchase decisions under pressure when the market is volatile dollar cost averaging may be especially useful to beginning investors who don t yet have the experience or expertise to judge the most opportune moments to buy it can also be a reliable strategy for long term investors who are committed to investing regularly but don t have the time or inclination to watch the market and time their orders however dollar cost averaging isn t for everyone it isn t necessarily appropriate for those investing time periods when prices are trending steadily in one direction or the other be sure to consider your outlook for an investment plus the broader market when making the decision to use dollar cost averaging bear in mind that the repeated investing called for by dollar cost averaging may result in higher transaction costs compared to investing a lump sum of money once 1special considerationsit s important to note that dollar cost averaging works well as a method of buying an investment over a specific period of time when the price fluctuates up and down if the price rises continuously those using dollar cost averaging end up buying fewer shares if it declines continuously they may continue buying when they should be on the sidelines so the strategy cannot protect investors against the risk of declining market prices like the outlook of many long term investors the strategy assumes that prices though they may drop at times will ultimately rise using this strategy to buy an individual stock without researching a company s details could prove detrimental as well that s because an investor might continue to buy more stock when they otherwise would stop buying or exit the position for less informed investors the strategy is far less risky when used to buy index funds rather than individual stocks investors who use a dollar cost averaging strategy will generally lower their cost basis in an investment over time the lower cost basis will lead to less of a loss on investments that decline in price and generate greater gains on investments that increase in price example of dollar cost averagingjoe works at abc corp and has a 401 k plan he receives a paycheck of 1 000 every two weeks joe decides to allocate 10 or 100 of his pay to his employer s plan every pay period he chooses to contribute 50 of his allocation to a large cap mutual fund and 50 to an s p 500 index fund every two weeks 10 or 100 of joe s pre tax pay will buy 50 worth of each of these two funds regardless of the fund s price the table below shows the half of joe s 100 contributions that went to the s p 500 index fund over 10 pay periods throughout 10 paychecks joe invested a total of 500 or 50 per week the price of the fund increased and decreased over that time the results of dollar cost averaging joe spent 500 in total over the 10 pay periods and bought 47 71 shares he paid an average price of 10 48 500 47 71 joe bought different share amounts as the index fund increased and decreased in value due to market fluctuations the results if joe spent one lump sum say that instead of using dollar cost averaging joe spent his 500 at one time in pay period 4 he paid 11 per share that would have resulted in a purchase of 45 45 shares 500 11 there was no way for joe to know the best time to buy by using dollar cost averaging though he was able to take advantage of several price drops despite the fact that the share price increased to over 11 he ended up with more shares 47 71 at a lower average price 10 48 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