“Buy low and sell high.” This is probably the simplest explanation of how to be a successful investor.
Simple doesn’t make it easy, though. Nobody has a crystal ball allowing them to see into the future so they know when to buy securities at the lowest possible price and sell them at the highest possible price. But this doesn’t stop many investors from trying to time the markets in order to buy low and sell high.
A Better Strategy
A better alternative for many investors is a strategy known as dollar-cost averaging. This strategy reduces the risk of purchasing securities at or near a market peak. Instead, investment purchases are spread out evenly over time, which could result in purchasing more shares at lower prices and fewer shares at higher prices.
With dollar-cost averaging, you will invest the same amount of money at regular intervals, such as monthly or each pay period. The strategy is commonly used with retirement savings plans such as 401(k)s where money is deducted from gross pay and transferred directly into the participant’s retirement account.
Dollar-cost averaging takes away the guesswork of trying to time the markets by buying low and selling high. It also makes investing automatic — you don’t have to remember to transfer money into your retirement account every month. Removing the human element of investing can result in a larger nest egg at retirement.
The strategy can also even out share purchase prices over time. When the market is down, your money purchases more shares. The opposite is also true: When the market is up, your money purchases fewer shares. Over the long term, this could lower the average cost per share.
Benefits of Dollar-Cost Averaging
There are three main potential benefits of dollar-cost averaging:
- It eliminates the temptation to try to time the markets — which is difficult, if not virtually impossible, for even professional investors to do.
- It takes emotions out of the equation. When it comes to investing, emotions generally aren’t your friend.
- It forces you to adopt a long-term perspective, which is beneficial when investing for goals like retirement or children’s college educations.
An example helps illustrate the potential benefits of dollar-cost averaging:
John contributes $1,000 each month to the 401(k) plan he participates in at his workplace, where the money is invested in a low-cost, well-diversified mutual fund. Over a five-month period, the mutual fund share prices were $20, $16, $12, $17 and $23. During these months, John’s contributions bought 50, 62, 83, 58 and 43 shares.
After 5 months, John has bought a total of 296 shares for $5,000, or an average share price of $16.90. This is more than $3 per share less than he would have paid had he invested the entire $5,000 in one lump sum at $20 per share during the first month.
“But John would have enjoyed a lower share price of $12 if he’d invested all the money in the third month,” you might be thinking. Yes, but this goes back to the uncertainty of trying to time the markets. By choosing dollar-cost averaging, John removed uncertainty from the investing equation and ended up with a lower share price than if he’d invested a lump sum in three of the five months.
Dollar-cost averaging can be especially beneficial during market downturns because it allows you to buy securities when prices are low. Sometimes it can be hard emotionally to invest when the markets are down and everybody else is selling, but dollar-cost averaging forces you to buy “on the dips” and thus benefit from lower per-share prices.
A Viable Long-Term Strategy
Short of a crystal ball, there aren’t many strategies better than dollar-cost averaging that can help investors achieve long-term success. Please contact us if you have more questions about dollar-cost averaging and how it could help you meet your investing goals.