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Understanding Dollar-Cost Averaging
Some investors get a thrill from trying to choose the right moment to invest. But predicting the market is difficult even for professionals. Dollar-cost averaging can take the emotion and guesswork out of investing. Is it right for you?
A dollar-cost averaging strategy boils down to this: You invest a specific dollar amount at regular intervals regardless of the investment's share price. With this approach you can opt out of the guessing game of trying to buy low and sell high.
By investing on a regular schedule, you can take advantage of market dips without worrying about when they'll occur. Your money buys more shares when the price is low and fewer shares when the price is high, which can mean a lower average cost per share over time.
Commitment prevents guesswork
The most important element of dollar-cost averaging is commitment. How frequently you invest (monthly, quarterly or even annually) is less important than sticking to your investment schedule.
This disciplined approach can take much of the worry out of investing and helps remove the temptation to try to time the market.
Dollar-cost averaging in a rising market
In the illustration below, $500 is invested in a mutual fund on the first of each month for 6 months. By dollar-cost averaging, an investor would spend $3,000 methodically acquiring 109.89 shares at an average cost of $27.30 each. When buying shares at specified intervals, there's no guesswork or worry about what the price is about to do.
Dollar-Cost Averaging as the Share Price Rises
For illustrative purposes only. Not intended to represent or predict the performance of any specific Franklin Templeton fund.
Dollar-cost averaging in a falling market
Now consider $500 monthly investments as the fund's share price is falling. Dollar-cost averaging in this scenario reduced the loss, compared to a lump-sum investment. Six regular investments would have bought 98.63 shares at an average cost per share of $30.42.
The investment's value at the end of the period in this particular scenario would be $2,564.38. By comparison, someone who invested the full amount in January at $38 per share would have owned only 78.95 shares, and the investment would have been worth only $2,052.70 at the end of the period.
Dollar-Cost Averaging as the Share Price Falls
For illustrative purposes only. Not intended to represent or predict the performance of any specific Franklin Templeton fund.
Dollar-cost averaging doesn't guarantee a profit or eliminate risk, and it won't protect you from a loss if you sell shares when the market is declining or at a low point. Before adopting this strategy, you should consider your ability to continue investing through periods of low price levels or changing economic conditions.
Who should use dollar-cost averaging?
Many 401(k) plan participants are using this strategy by default because they contribute every month through payroll deductions. But dollar-cost averaging can be useful outside of these plans, too.
Avoiding minimum investment requirements. Dollar-cost averaging can provide a way to invest in funds with high minimum investment requirements. Fund companies will often waive this requirement for investors who set up an automatic investment plan.
Smoothing out volatility. Dollar-cost averaging is also popular among those who invest in volatile funds. If a fund's share price fluctuates frequently, dollar-cost averaging can help reduce the average cost per share over time.
The bottom line
Dollar-cost averaging is not for everyone, but many investors believe this systematic approach to investing is an effective way to accumulate wealth over the long term.
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