Investors can use dollar-cost averaging to protect their investments in several different ways:
1. Dollar-cost averaging keeps you from buying only at the top of a market
It’s a good way to ensure you don’t put a large sum of money into the market at one time called lump-sum investing–and then worry that you invested the money at the wrong time.
Dollar-cost averaging works by easing into the market, allowing you to purchase shares over an extended period of time. By doing it this way, you have several opportunities to purchase the stock over time, and can diversify the price you’re paying. It also allows investors to pick up more shares when prices are lower and fewer shares when prices are higher.
2. Dollar-cost averaging creates discipline
Dollar-cost averaging can create investment discipline because it requires you to put a fixed amount of money into the market on a regular basis. The most common way this strategy is put to work is by deducting a fixed sum from your paycheck on a monthly basis.
This approach gets you used to being in the market. But it also ensures that your money is consistently invested over time. Rather than trying to time the market, many long-term investment strategies succeed based on the length of time money is invested.
3. Share price diversification
The biggest advantage of dollar-cost averaging is the way it can help you diversify share price over time.
Investors often fear that lump-sum investing will get them into the market at the wrong time. This is most often displayed when a stock price rises. As the share price increases in value, investors might worry it could go down. And so they might wait for a better entry opportunity. In the meantime, the share price could go up significantly.
This leaves the investor on the sideline during this appreciation period and may present an even worse entry point when the investor finally gains enough confidence to buy.
By contrast, dollar-cost averaging puts money to work right away, getting the investor in on the ground floor.
As the share prices rises, the fixed amount of money that is being invested each month buys fewer and fewer shares. This can provide comfort to investors who fear they could be overpaying for a stock that is going up in price.
4. It can remove emotions from investing
Dollar-cost averaging helps to take the fear out of investing. If you’re a first time investor, you might feel frustrated with share price movements. You might worry when you buy a stock and see its price go down later. If this frustration is too great, it can prevent someone from becoming an investor altogether.
Remember though, holding money only in cash erodes its purchasing power over time due to inflation. A dollar-cost averaging investment strategy can be put in place and then largely forgotten. The main factors that you need to decide are how much money to invest regularly, and what securities to buy.
But with some many diversified ETFs on the market today, an individual investor can create a diversified portfolio, with very little cost or effort.
5. Get the most out of your retirement account
Dollar-cost averaging can help you maximize your employer-sponsored retirement account plan. Most companies will partially or fully match contributions that employees make into their retirement account plans. This gives you additional purchasing power by allowing you to buy more shares.
Over an extended period of time, these contributions can add up.