Most of us understand the meanings of “dollar” and “cost”, and we know what averages are…
But when you put those three words together – dollar cost averaging – the meaning may not be quite as clear.
Dollar cost averaging refers to the concept of investing on a fixed schedule and with a fixed amount of money. For example, after a careful budget review, you might determine you can afford $200 per month to invest. With dollar cost averaging, you would invest that $200 without regard to what the market is doing, without regard to price, and without regard to news that might impact the market temporarily. You become the investment equivalent of the tortoise from the fable of the tortoise and the hare. You just keep going steadily.
When the market goes up, you buy. When the market goes down, you can buy more.
The gist of dollar cost averaging is that you don’t need to be a stock-picking prodigy to potentially succeed at investing. Over time, as your investment grows, the goal is to profit from all the shares you purchased, both low and high, because your average cost for shares would be below the market price.
Hypothetically, let’s say you invest your first $200 in an index fund that’s trading at $10 per share. You can buy 20 shares. But the next month, the market drops because of some news that said the sky was falling somewhere else in the world. The price of your shares goes down to $9.
You might be thinking that doesn’t seem so great. But pause for a moment. You’re not selling yet because you’re employing dollar cost averaging. Now, with the next month’s $200, you can buy 22 shares. That’s 2 extra shares compared to your earlier buy. Now your average cost for all 42 shares is approximately $9.52. If your index fund reaches $10 again, you’ll be profitable on all those shares. If it reaches $12, or $15, or $20, now we’re talking. To sum up, if your average cost goes up, it means your investment is doing well. If the price dips, you can buy more shares.
Using dollar cost averaging means that you don’t have to know everything (no one does) and that you don’t know for certain what the market will do in the next day, week, or month (no one does). But over the long term, we have faith that the market will go up. Because dollar cost averaging removes the guesswork involved with deciding when to buy, you’re always putting money to work, money that may provide a solid return in time.
You may use dollar cost averaging with funds, ETFs, or individual stocks, but diversified investments are potentially best. An individual stock may go down to zero, while the broad stock market may continue to climb over time.
Dollar cost averaging is an important concept to understand. It may save you time and it may prevent costly investment mistakes. You don’t have to try to be an expert. Once you understand the basics of dollar cost averaging, you may start to feel like an investment genius!