Dollar-cost averaging is a strategy that many investors use. Essentially, when leveraging dollar-cost averaging, investors invest a set amount of money by purchasing a target asset on a set schedule, regardless of current market conditions. The idea behind this approach is that, rather than timing the market, you’re reducing the impact of market ups and downs on your portfolio because you’re always investing.
Sometimes, this means you’ll be buying into the market when prices are high. Other times, you’ll be buying into the market during a downturn when prices are low. By focusing on consistency instead of market timing, investors may be able to offset the impact of market volatility and continually grow their nest egg in accordance with their long-term goals.
A Real-Life Dollar Cost Averaging Example
Most investors are already leveraging dollar-cost averaging without even realizing it! When investors contribute to their 401(k), they’re doing so on a set schedule. Every paycheck, a percentage of their income is deferred into the account.
These contributions are made bi-weekly (or whenever they’re getting paid) regardless of what’s going on in the market. The account value may fluctuate over time, but it’s ultimately going to steadily grow year after year as contributions continue to keep it well-stocked.
Pros of Dollar-Cost Averaging
There are several benefits to dollar-cost averaging:
- First and foremost, it helps investors to build consistent investing habits. When it comes to growing wealth, consistency is key!
- When an investor leverages dollar-cost averaging, they’re creating a strategy that aligns with Goepper Burkhardt’s investment philosophy: passive investment management and long-term planning. They’re not chasing market returns, and are instead trusting in the long-term growth of the assets they’ve selected that are in alignment with their goals and retirement horizon.
- If asset prices rise with time, dollar-cost averaging can be beneficial as the total value of an investor’s portfolio will grow with each consistent contribution to their various accounts.
Cons of Dollar-Cost Averaging
Investors may feel some pause when it comes to a dollar-cost averaging. After all, if an investor is buying too many shares of an asset at a higher price point, they may be losing the potential for some capital gains in the short term. Investors who have a large amount of capital may also lose the chance to take advantage of compounding interest if they try too hard to “pace” their investments over time.
Dollar-Cost Averaging Vs. Lump Sum Investing
This is where the true question of investing strategy comes into play: should you invest all of your money at once, or follow a dollar-cost averaging plan of action? There are several different views on this question. Let’s look at a few options in the context of an example:
Let’s say you got a $10,000 inheritance. Should you invest it all in a lump-sum? Or pace your investing in dollar-cost averaging? In this case, Vanguard says a lump sum may yield higher returns (66% of the time that was true, according to their study). However, it’s also wise to evaluate your own goals and risk tolerance before diving in. A few questions you might ask yourself are:
- If you invest a large lump sum of money (from an inheritance or otherwise) at once, will you be comfortable if the market suddenly drops and you lose money in the near term?
- Is your lump sum investment properly allocated for your goals?
- Do you know what you want to use this lump sum investment for? Will it contribute to your retirement? Or is there another goal on the horizon you’re pursuing?
If you’re feeling as though your goals are shifting, or if you have multiple objectives you want a lump sum to achieve, dollar-cost averaging may make more sense. For example, you could break a $10,000 inheritance into $1,000 monthly investments that each go toward different accounts (your grandchild’s 529 Plan, your retirement account, or your brokerage account for short-term goals).
Build a Comprehensive Investment Plan
Regardless of the strategy you choose to pursue, partnering with a financial planning professional can help. Your investments shouldn’t be viewed as a siloed part of your financial life. True financial wellness comes from a comprehensive plan that incorporates your investments as one component of many. A financial planner can help you to identify your goals and values, and reverse engineer a financial plan (and investment strategy) rooted in them.
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