How much are you putting towards your 401k plan each month? If $50 is automatically subtracted from your paycheck each month to put towards your retirement savings then you are already practicing the concept of dollar cost averaging.
Dollar cost averaging refers to the practice of investing the same amount for a set time period—such as each month or each week—for securities like stocks, bonds or mutual funds. For the small investor, mutual funds are preferred because they offer diversification at a lower cost. This kind of investment strategy enables the investor to lower market risk because the investments are spread out. As a result, the investor gets the benefit of protection from the fluctuations in the market price. When the stock price rises, the investor will only be able to buy fewer shares with your investment amount. However, when the price falls, you will be able to buy more shares.
Let’s say you can only spare $100 to invest in Stock A each month. If the price of each share is $20, you are able to buy 5 shares of the stock. Next month, the price drops to $18, so you are able to 5.5 shares. On the third month, the price goes up to $22. At this rate, you can only buy 4.5 shares. History has shown however that this kind of strategy, when followed over time, will result to you making more investments and increasing your returns.
While dollar cost averaging gives you the chance to earn more from your investments even when you only invest a small amount each month, you have to remember that the gains you make can be eroded with transactions costs, such as the commissions or loads, imposed by the brokerage firm. This is something you should avoid. You can find discount brokers that don’t levy transaction costs when you make regular investments to a mutual fund.
You can easily set up a dollar cost averaging plan with a discount broker. Doing so is simple but you’ll need to do some calculations first.
First, look at your budget to determine how much you can actually invest each month. Make sure that you can really afford this amount without fail. Dollar cost averaging can only work to your advantage if you are consistent with the amount you put towards your chosen investment.
Then, choose a security that you want to keep on investing in for a long time, preferably at least ten years. You can invest in individual stocks or bonds but it can be difficult to make a diversified portfolio if you only have a limited amount. Thus, mutual funds and index funds would be better options for investors who don’t have a lot of money on their hands.
Finally, invest the money in the security you have chosen. It would be ideal if you automate the process. By ensuring that your investment amount is automatically withdrawn from your account, you don’t have to worry about writing a check for it every month. When it’s automated, you won’t miss making your investment and can maximize the returns of dollar cost averaging.
Index funds are mutual funds that mirror the performance of benchmarks like the S&P 500, the Wilshire 5000 or the Dow Jones Industrial Average. When you invest in an index fund, you basically get to own a fractional interest in each of the 500 stocks that comprise the index. As such, you get the benefit of a diversified portfolio with just a single investment. In addition, you also won’t have to fork out a lot of money on management fees because index funds are passively-managed funds. You’ll still have to pay these fees but they are a mere tenth of the fees collected by other mutual funds that are actively-managed. As a result, most of the returns are going to go to your pockets and not to the fund manager.
When you utilize dollar cost averaging for your mutual fund investment, you are bringing down market risk. Because index funds track the returns of the companies making up the benchmark, the risk of one company performing poorly is also lessened. Since both market risk and company-specific risk are reduced in this type of mutual fund, index funds are among the best choice for small time investors who intend to increase their wealth portfolio by making investment in equities.
If you are thinking of only using dollar cost averaging as a short-term investment strategy, be warned that you won’t make the most of it if you do so. Despite the fluctuations that mark the financial markets, the direction they follow occurs for months and even years. Because of the nature of these movements, you can’t rely on dollar cost averaging if your investment period will only last for only a year or two.
The reason for this is very obvious if you consider the prices of shares of a mutual fund that you will purchase in just a couple of months. While there might be a very slight difference in the prices of these securities, it’s very unlikely that it will vary substantially in a few months or even a year.
If you have a 10-year market cycle in mind, however, you will see a significant change in their prices. In that span of time, the market will have undergone both bull and bear markets and as such, your investment amount will be able to benefit from the discounts given when the market isn’t performing well even if it will only be able to purchase fewer shares when the market is on a roll.
To maximize the dollar cost averaging strategy, here are some tips to keep in mind:
1. Be wary of mutual fund fees which can erode your returns.
Make sure that you are fully aware of the fees charged by the mutual fund for your investments. Some will say that the loads they charge are minimal but you should make it a point to read all the documents pertaining to your investment before you actually give your money. Expenses can easily lower your returns with time so choosing the fund that charges the lowest fees will be to your advantage.
2. Stick to your plan.
The only way for dollar cost averaging to give you the returns you seek is if you are dedicated to your plan. If you bail out in the middle because the market suddenly experienced a downturn, you’ll really lose a lot. Despite the urge to bolt when the market becomes shaky, you should stick to your plan and ride it out as the market has proven that it will eventually right itself in the long-term.
3. Choose your security investments carefully.
If you are serious about dollar cost averaging as an investment strategy, make sure that you choose the security carefully. As mentioned above, individual stocks aren’t really practical choices for the investor with limited funds. Go for index funds with very low management fees or other types of mutual funds that don’t collect loads. No matter what asset class you choose to pour your money in, see to it that you comparison shop first before actually deciding on the investment of your choice.
Dollar cost averaging is a sound long-term strategy for investors with limited funds seeking to build their investment portfolio. What makes this practical is the fact that it removes the emotional aspect of investing. When you have a dollar cost averaging plan in place, you invest the amount month after month no matter what the market’s condition is. When the market is down, your investment amount can buy more shares. When the market is up, you get to purchase fewer shares. Over time, however, you’ll get to profit more from your investments. For as long as you stay true to this strategy, you’re bound to reap results down the road.