Investing your money isn’t easy. There are tons of high-pressure decisions to be made and the amount of information you have to sort through to find the quality stuff is near impossible sometimes. Despite this, it’s important to push through the difficulties in order to help out your future self in retirement.
There are a variety of systems, techniques, and choices that make investing less complicated. One of these techniques is called dollar-cost averaging which makes the most of your investing dollars and negates the risk of investing, all without having to kill yourself with numbers and analysis.
Let’s take a closer look at why you should consider dollar-cost averaging for your retirement savings.
The Goal of Dollar-Cost Averaging
The biggest fear of any investor is plopping down $5,000 at the start of the year in a Roth IRA and seeing the market crumble the next day. Dollar-cost averaging makes sure this doesn’t happen by splitting up that $5,000 into smaller investments, say 10 investments of $500 each, over a certain interval of time, maybe 6 months or a year.
This techniques allows the daily ups and downs of the market to have less of an effect on your investment. The end goal is achieving maximum value for each investing dollar.
When the market is doing well, it’s not a good time to buy so you’ll purchase less shares. When the market is doing poorly, it’s a good time to buy, so your money will buy more shares.
Dollar-cost averaging is simple because it does away with our irrational minds worrying ”when should I invest?” Once you have a system set up, you make the purchases monthly, bi-weekly, etc. and move on. You don’t have to watch the market from day to day and you won’t get burned by a big market swing or a decision made on emotion instead of numbers.
An Example of Dollar-Cost Averaging
We’ll use the numbers from above. You want to invest $5,000 in a Roth IRA with a Vanguard index fund starting in January and ending in December.
Once a month on the 1st you will buy $416 worth of stock. You can actually set up your investing account to automatically make this purchase and you won’t even have to remember the purchase every month.
It doesn’t depend on the price of the fund, you will make a purchase on the 1st of the month for $416 worth of stock. Say the fund is $32 in January for your first purchase; your first purchase will buy you 13 shares.
The next month you also buy $416 worth of stock – regardless of the price. This time the stock went down to $25 so you bought 16.64 shares. This continues for the rest of the year until you max out in December at $5,000.
When the market is down and in your favor, you’ll buy more shares. When the market is higher and not a buyer’s market, you’ll purchase less shares but keep your investment moving forward.
Who Should Use Dollar-Cost?
In order to maximize your return on investment, it’s best to purchase a lump sum of stock at one-time. This makes the most of compound interest, dividends, and any large market gains. But for those who are a little more conservative with their investments, dollar-cost averaging is helpful.
If your questioning how useful dollar-cost averaging is, put yourself in the shoes of people who made lump sum investments on October 6, 2008. This was the Monday of Black Week which saw the Dow lose almost 18% in the following 5 days. A $10,000 investment on Monday was worth just $8,200 on Friday – a loss of $1,800!
You won’t make as much as possible with dollar-cost averaging, but you’ll stay away from huge losses that devastate your future and investing morale.
Dollar-cost averaging is also helpful for beginning investors or people who don’t have a lump sum to invest. You can base your dollar-cost investing schedule on your paychecks and the cash you have available per month. Using this system, you can guarantee you’ll get the best value for each individual dollar you invest.
Photo: David Paul Ohmer
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[...] Dollar-Cost Averaging Takes the Stress Out of Investing by Austin Morgan from Foreigner’s Finances is an excellent explanation of using dollar-cost averaging if you’re just getting started in investing and don’t want to take too much of a hit if the market goes kablooey (again). [...]
[...] Foreigner’s Finances: Dollar-Cost Averaging Takes the Stress Out of Investing [...]