Regardless of a security’s price, dollar-cost averaging is the practice of consistently investing equal sums of money at regular intervals. Find out more in this guide!
What is dollar cost averaging?
Dollar-cost averaging is buying stocks or mutual funds in small amounts over time. Dollar-cost averaging may happen if you regularly invest in an IRA or 401(k). This strategy means investing when the market or a stock is down and when investors can get the best deals.
Using dollar-cost averaging can be particularly effective during economic downturns and bear markets. Suppose you put away $300 every month in an investment. When the market is doing well, $300 will buy fewer shares than when it is doing poorly, but when the market is doing poorly, $300 will buy more shares. Compared to what you would have paid if you had purchased all of your shares at once when they were more expensive than the average, this strategy can lower your average cost per share with time.
How Does Dollar Cost Averaging Work
An investor can save money and build wealth over time with dollar-cost averaging. It is also a way for an investor to overlook short-term volatility in the market.
Long-term dollar-cost averaging is used in 401(k) plans, where employees regularly invest no matter the price. This is a good example.
Employees can choose the amount they want to contribute and the investments offered by the plan in which to invest with a 401(k) plan. The investments are automatically made every pay period. Depending on market conditions, employees’ accounts may have more or fewer securities.
Outside 401(k) plans, dollar-cost averaging can also be used. Investors can, for example, use it to make regular purchases of mutual or index funds, whether in a traditional IRA or a taxable brokerage account.
Dollar-cost averaging is an excellent strategy for beginning investors interested in trading ETFs. Because of this, many dividend reinvestment plans let investors average the cost of their purchases by making them often.
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