Financial Tip Friday: Dollar Cost Averaging and Why You Need to Do it

Financial Tip Friday: Dollar Cost Averaging and Why You Need to Do it

One of the topics that I love to talk about most on this blog is investing. I love discussing different strategies, amounts, investments, and other items. I have talked about why I chose to investment accounts over pensions, investing at least 15% of your income, how much you should save in general, the different types of investments, asset allocationrisk tolerance, as well as other topics. However, once you have made the decision about what kinds of investments to put in, how much to put in, and what kinds of risk you can handle, how do you invest your money, particularly any kind of money that exists outside of an employer based retirement account?

The answer: Dollar Cost Averaging.

What Is Dollar Cost Averaging?

Dollar cost averaging is simply investing a set amount of money at regular intervals over a long period of time. It is very similar to how you would invest in a 401k plan at work. Save you make $50,000 and you elect to have 10% of your income put into a 401k plan. Depending on how many times you get paid during the year they will take a set amount every week, two weeks, monthly, or even quarterly and put it in that 401k account.

With that money you will automatically purchase units of the specific investments that you have chosen. However, dollar cost averaging can be a bit different if you have an IRA or are self-employed and contribute to an retirement account that you set up yourself. It also differs if you have just a regular investment account at a brokerage firm.

Why Dollar Cost Averaging Is Important?

The reasons for dollar cost averaging are several but the most important, in terms of investing, is to really balance out your investments over the years. Let’s look at an example.

Let’s say you have a Roth IRA and you want to contribute the maximum amount of $5,500. You have a couple ways of doing this. First, you can just put in $5500 at the beginning of the year and be done with it. Second, you could just take money whenever you get it and contribute it at random times during the year. YOu might contribute $100 here, $1000 the next month, and then wait three months and contribute another $200, etc. The third way and what I believe is the most preferable is to choose specific intervals and contribute the same amount at every time every week, month, quarter, whatever.

There are several reasons to dollar cost average instead of just contributing one lump sum or doing it on a random basis.

  1. Predictability. If you put this as part of your budget then you can anticipate when this will go into your investments. You don’t have to worry about the winds of windfall from month to month.
  2. Balances out your investments. If you were to have put in the maximum amount of your IRA or other investment account at the beginning of the year you would’ve actually lost money over the year. With dollar cost averaging you buy units of your investments at what they are worth at that moment. However, that investment could be lower or higher in six months. Dollar cost averaging allows you to buy more units at lower prices if the market were to go down. And practically every year the market does go down at least a little during  the year. It does go up continually, even in a good year.
  3. You can invest with a small amount of money. You don’t need to have large amounts of cash right away to begin investing.
  4. Over time dollar cost averaging will pay off because you will more than likely to be buying at lower prices and selling at higher. You buy more units of an investment at a lower price so that when it goes up your return goes up.

The Bottom Line: Dollar cost averaging is really one of the best ways to dole out your yearly investments. People rarely have $5000 just lying around. And if you do I might advise you to contribute all of it to your investment account, but put that money into a money market account in the investment account and then each month on a specific date you transfer x amount of dollars to your specific investments. Therefore, you can contribute, if you want, all of your money directly to your investment accounts right away, but still engage in dollar cost averaging.

 

Comments are closed.