What is Dollar-Cost Averaging?
Dollar-cost averaging, also known as the constant dollar plan, is an investment strategy that helps you make periodic purchases of a target asset.
With this strategy, you’ll make purchases at regular intervals regardless of the asset’s price. Dollar-cost averaging can save you a lot of time. You don’t have to constantly watch the market to get the best price.
How to build an investment portfolio with dollar-cost averaging
Dollar-cost averaging is a tool you can use to help build savings, wealth, and grow your portfolio over a long period of time. A perfect example of dollar-cost averaging in action is 401(k) plans.
With a 401(k) plan, you select an amount to be deducted from your salary, which is used to purchase target assets. These purchases occur at regular intervals, regardless of the market price. When the investment price is low, you’ll buy more shares; when it’s high, you’ll buy fewer.
But you can use dollar-cost averaging outside of a 401(k) plan as well. A lot of investors use it for mutual or index fund accounts. And many dividend reinvestment plans allow you to use this strategy as well.
Dollar-cost averaging assumes that prices will eventually rise. Using this strategy on individual stocks can be risky. You might wind up buying more shares in a company when you should actually sell and cut your losses. So, if you’re using dollar-cost averaging on individual stocks, make sure you keep up with details about the company’s earnings and losses.
For beginning investors, using this strategy is less risky on index funds than individual stocks.
Using a dollar-cost averaging strategy aims to lower your cost basis in an investment over time. A lower cost basis will lead to smaller losses on investments that decline and bigger gains on those that improve.
Remember, this strategy cannot protect you against assets that are in constant decline or in a market that is suffering consistent losses. So, it’s still important to check-in from time to time.
Why use dollar-cost averaging?
By using a dollar-cost averaging approach, you can avoid the risk of making hasty decisions, such as buying more when prices are rising or panic-selling if a stock starts to fall.
Instead, you can focus on contributing a set amount of money each period regardless of the price. This way, your investment strategy will be more of a steady, long-term approach. It is best to stay away from rash decisions based on greed or fear.
Dollar-cost averaging example
An example of this strategy would be investing $500 per month in an index fund that tracks the performance of a certain market, such as the S&P 500.
Some months, the index could be high, so you’ll get less shares for the $500. Other months, the index could be low, so you’ll get more shares for the same investment.
When you use a dollar-cost averaging approach, you’re betting that the simple “set it and forget it” strategy, and the fact that you avoid the temptation to buy high and sell low, will lead to better results than trying to constantly monitor the market and make the perfect purchase at the right time.
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