As you might guess, one of the most common investment questions we receive on our Financial Coaching Line is about when to buy and when to sell investments to maximize returns. My most common answer to that question is that if I knew precisely when to buy securities at the perfect price with perfect consistency, I would be answering that question from my private island. In all seriousness, the up and down nature of investing often causes investors to hit pause on executing their long-term investment plans, which can cause serious harm to their long-term results. Investment paralysis can cause you to miss out on the best returns in the market. If you are looking to buy and hold for the long run, there is a method of purchasing shares that can help you ride out the ups and downs of the market and potentially improve your returns over time: dollar-cost averaging.
Dollar-cost averaging is easy to implement
The beauty of dollar-cost averaging is its simplicity. All you do is invest the same amount of money in your desired investment on a consistent basis over time (say every two weeks or each month aka when you get paid). When the share price is high, the number of shares you will get for your investment dollars will be lower and when the share price goes down, you’ll get more shares for your money. You might already be using dollar-cost averaging. If you participate in your employer’s 401(k) or other retirement plan, the same amount of money is deducted from each paycheck and then invested per your selections.
Dollar-cost averaging works
Because the stock market goes through many ups and downs over time, the odds of you being able to predict or pinpoint the lows with any consistency are extremely slim. This makes it unlikely that waiting and then investing all your money at once will pay off over the long-term. But those fluctuations create the perfect conditions for dollar-cost averaging to work its magic.
An example of dollar-cost averaging leading to higher returns
Let’s say you’ve set up a program of investing $100 a month in an exchange-traded fund. The fund share price generally hovers around $10 so you typically get about 10 shares for your monthly investment. But one month the market experiences a downturn, and the share price drops to $5. Your $100 investment buys you 20 shares.
You now own more shares that will be worth more when the market returns to its usual level. In this example, dollar-cost averaging results in a 33% return for our investor. Not bad for someone who set up a simple investment plan and stuck to it.
Note: This is a hypothetical example and is not representative of any specific situation. Your results will vary.
Dollar-cost averaging is not for everybody
Of course, dollar-cost averaging can have its downside. Such a strategy does not assure a profit and does not protect against loss in declining markets. If you are an active trader with a significant conviction about the price of a stock or ETF, you probably have zero interest in allowing your purchase price to be picked at random. If you want to try something a little more active than traditional dollar-cost averaging, consider accelerating your purchases if you see a dip in the price of your desired investment. For instance, if you are dollar-cost averaging $10,000 into an investment over 10 months you can decide that if there is a significant reduction in the price of the security, say 15-20%, you can double your investment that month of the market dip.
Dollar-cost averaging helps change how you think about investing
When you are consistently investing every month, your mentality about the market and market news changes. A month or so ago, there was news about the market hitting all time highs. In a dollar-cost averaging plan, I know my buying power is automatically buying fewer shares.
At the writing of this post, the dominate market news is about a new virus variant and CEOs taking significant profits. Could we be headed for a market dip? If so, my dollar-cost averaging plan will be buying more shares while the market is down.
Investing does not have to be complicated
If you’re like most people though, you’ll probably prefer to make dollar-cost averaging something you don’t have to think about. Most investment companies give you the option to set up automatic transfers from your checking account directly into your investment account, making investing on your own just about as easy as accumulating a nest egg in a 401(k) plan. If you’re not already taking advantage of dollar-cost averaging, start now. As the old saying goes, time is money!