Being a young professional myself, I have the privilege of working with other young professionals who are getting started investing. One investment strategy I sometimes recommend to these investors is called dollar cost averaging. Dollar cost averaging refers to investing a fixed dollar amount at regular intervals. It allows an investor to build an investment by purchasing shares over time.
By investing a fixed dollar amount, this strategy causes the investor to buy more shares when prices are low and fewer shares when prices are high. Because more shares are purchased when prices are lower, dollar cost averaging can result in a lower average purchase price per share than the average market price per share. This makes it an attractive way to start investing or to invest in times of uncertainty or volatility.
By way of example, let us assume that an investor, Average Joe, wants to invest $3,000 in his traditional IRA over the next three months using dollar cost averaging. Accordingly, he allocates $1,000 per month to purchase shares. The price per share of his chosen investment varies as follows: $100 at the beginning of month one, $110 at the beginning of month two, and $90 at the beginning of month three.
In this scenario, Average Joe’s $1,000 monthly investment purchases 10 shares in the first month, 9.09 shares in the second month and 11.11 shares in the third month for a total of 30.2 shares. Accordingly, the average share purchase price is $99.34 ($3,000 invested divided by 30.2 shares) relative to the $100 average market price per share.
Another potential benefit of dollar cost averaging is that it may limit investment losses. If an investment were to decline in value during the dollar cost averaging period, losses would be mitigated because some money has not yet been invested. In contrast, if an investment was made all at once as a lump sum, any declines would apply to the entire investment. Therefore, dollar cost averaging may help you manage risk, especially in times of market uncertainty.
Although dollar cost averaging does have some caveats that should be considered, it may be a useful strategy for reducing average purchase price per share while potentially limiting investment downside. This can make it a useful strategy for those getting started investing as well as in times of uncertainty and volatility.
To determine whether dollar cost averaging may be beneficial to you, I recommend that you consult your financial advisor. Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. In addition, such a plan does not assure a profit and does not protect against loss in declining markets.
Do you have any questions about dollar cost averaging or getting started investing? Send me a question using the ‘Have a Question?’ box below or leave me a comment on LinkedIn.