This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
When thinking about investing, one consideration is whether to invest funds all at once or over a period of time. If you choose the latter route, you might be opting for an investment strategy called dollar-cost averaging.
With dollar-cost averaging, you invest your money in equal portions, at regular intervals, regardless of the ups and downs in the market.
Let's say you receive a bonus or have saved up $10,000 to invest. Instead of investing that amount all at once, with dollar-cost averaging you might split that $10,000 into 10 parts and invest $1,000 a month for 10 months.
You might already be engaging in dollar-cost averaging and not even know it. If you have a 401(k) [employer-contributed retirement fund, similar to Australian superannuation] or another type of defined contribution plan, your contributions are allocated to one or more investment options on a regular, fixed schedule, regardless of what the market is doing. Every time this happens, you're dollar-cost averaging.
Before you start divvying up your money, here are three things to know about dollar-cost averaging:
Why might someone consider dollar-cost averaging?
It would be great if we could buy stocks, or other types of investments, when the market is low and sell when the market is high. Unfortunately, efforts to "time the market" often backfire and investors end up buying and selling at the wrong time.
When stocks go down, people often get fearful and sell. Then, when the market goes back up, they might miss out on potential gains. On the flip side, when the stock market goes up, investors might be tempted to rush in. But they could end up buying just as stocks are about to drop.
Dollar-cost averaging can help take the emotion out of investing. It compels you to continue investing the same (or roughly the same) amount regardless of the market's fluctuations, potentially helping you avoid the temptation to time the market.
When you dollar-cost average, you buy more shares of an investment when the share price is low and fewer shares when the share price is high. This can result in paying a lower average price per share over time.
And by wading in, as opposed to handing over your money all at once, dollar-cost averaging can help you limit your losses in the event the market declines.
What are the potential downsides of dollar-cost averaging?
Dollar-cost averaging can be a helpful tool in lowering risk. But investors who engage in this investing strategy may forfeit potentially higher returns. With dollar-cost averaging, you're holding onto your money as cash longer, which has lower risk but often produces lower returns than lump-sum investing, especially over longer periods of time.
If the market goes up during a period when you're dollar-cost averaging, you might miss out on the potential gains you could have had, had you invested right away in one fell swoop.
Of course, this doesn't apply to something like your 401(k) because, in that situation, you're investing the money as you earn it, not holding money in cash until a later date.
Also, keep in mind that if you engage in dollar-cost averaging, you might encounter more brokerage fees. These fees could erode your returns. And you also need to be disciplined with that money that's sitting on the sidelines in order to actually eventually invest it and not erode it with purchases.
What's the bottom line for investors?
As is the case in all aspects of investing, it's important to consider potential returns as well as your tolerance for risk.
Investing all of your money right away might yield higher returns than dribbling out smaller amounts over time.
But if you're looking to reduce your risk and control your emotions, or you're concerned about volatile market conditions, then dollar-cost averaging could be a viable strategy -- even if that means forfeiting some potential upside. If your main concerns are reducing short-term downside risk and avoiding feelings of regret after a potential loss, dollar-cost averaging might be right for you.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
