The concept of dollar-cost-averaging – the act of investing regular amounts in a systematic way every week or month – has been around for a long time. If you take $100 from each paycheck and add it to a stock mutual fund in your 401(k) every pay period, you are dollar-cost-averaging. If you add $500 every month to a mutual fund in your IRA, you are dollar-cost-averaging. You get the idea.
When markets decline, especially if they are quite volatile, dollar-cost-averaging can be a great strategy. It effectively forces you to buy more shares when prices are low and fewer shares when prices are high. Every month you continue to add more to your investment plan regardless of whether the market is up or down. This strategy takes the emotions out of investing and can result in a lower average cost per share of your favorite stock or mutual fund.
As long as markets are going down or sideways, this strategy works great. Dollar-cost-averaging doesn’t work so well when markets go up. In fact, in a rising market a dollar-cost-averaging strategy could result in a higher cost per share since every time you add more to your investment the share price may be higher.
Think of it this way: If you had $12,000 to invest today you could add it to a mutual fund all at once as a lump-sum or you could spread it out in equal installments over time – say, $1,000 a month for the next 12 months.
Spreading your investment out over time is known as the dollar-cost-averaging strategy I mentioned above. If markets go down while you are dollar-cost-averaging, $1,000 buys you more shares at lower and lower prices each month as your mutual fund share price declines.
However, if markets go up, your average share price could be higher with a dollar-cost-averaging strategy than if you had chosen to make a lump-sum investment all at once. This is because in a rising market your mutual fund share price is likely to be higher every time you buy more shares resulting in fewer shares purchased at ever rising prices. When stock prices go up, a lump-sum strategy may offer you the lower cost-per-share.
Which strategy works best for you? Your best strategy depends on your circumstances, time horizon and view of the markets. If you have a large lump-sum to invest, you have some choices. You could add money systematically over time (aka dollar-cost-averaging) or choose to lump it into the market all at once. If you don’t have a lump-sum to invest, dollar-cost-averaging may be your only option.
For those with long time horizons, maybe five years or more, there is a good chance that markets will be higher then than they are now. If you believe that to be the case, you may be wise to invest into the market all at once rather than drip it in over time. Keep in mind, stock prices could go down before they go up.
On the other hand, if you feel that the stock market is currently overvalued and likely to experience a significant downturn in the near future, dollar-cost-averaging may help you to take advantage of a short-term dip in the market while you accumulate more shares at lower prices.
What about Reverse Dollar Cost Averaging? Is that at thing? Read my post next week to find out.