What is dollar cost averaging?
If you are an investor, then you need to know what dollar cost averaging is. Dollar cost averaging is a vital concept for everyone to understand, whether you are just a daytime trader, a part time trader, a beginning trader, or more serious about your investments. So, let's take a look at dollar cost averaging and how it can help you reduce market risk and protect your investments.
Essentially, dollar cost averaging is an investment technique that specifically works to reduce the amount of market risk. The way that it does this is by buying securities at times and amounts already determined. So, rather than putting all your money in the stock market all at once, you are going to invest your money a little bit at a time over a longer period of time. This helps protect you against the variability of the market by spreading out your cost basis.
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So how can you start using dollar cost averaging in your investments? Just follow these easy steps to get started.
1. Decide on a monthly investment amount. Look over your budget and decide how much you can afford to invest. You need to choose an amount of money that you can handle every month-if you end up having to change the amount that you investment month to month because some months you can't afford it, then your investment approach will not be particularly effective, or at least not as effective.
2. Choose a place to invest. You will probably want to look into index funds. You will also want to choose an investment that you will want to hold on to for a long period of time-from five to ten years. This means that you don't want to invest in short term, high yield stocks. Index funds are a great idea because they are essentially mutual funds that are invested to give you returns about the same as the Dow Jones or the Standard and Poor 500. Investing in a passively managed index funds gives you the benefit of diversity with low management fees.
3. Invest your put aside money at specific intervals. Choose an interval, such as every week, every month, or every quarter, and stick with it. Invest that money in the same security every time, whether it's an index fund or a mutual fund or another security. You can even ask your broker to set up an automated withdrawal plan so that you don't even have to think about what's going on. Just remember to subtract the amount from your budget.
So does dollar cost averaging actually work? If you are a long term investor, dollar cost averaging can be one of the most profitable approaches to investment. It takes away the emotional component of investing that can lead to panic, trying to decide how your stock is doing, whether or not the yield is high enough, etc. Dollar cost averaging also takes away the panic and worry from trying to decide when exactly you should buy a stock-whether or not the price is going to go higher or lower, and if you are purchasing at the right time.
Retirement plans such as 401(k)s and 403(b)s actually already use dollar cost averaging investment approaches. These plans average the amount of money that you invest to safeguard your retirement account and maximize your investment power. Dollar cost averaging works itself out because you don't have to decide how many shares to buy each month-you simply invest the same amount of money, buying less shares the higher the price, and more shares the lower the price. The price that you pay averages itself out over time, and you really end up playing the market well because you aren't guessing the entire time.
