We all wish that our hard-earned savings could work harder to generate more returns passively. Truth is, saving your money is low risk, as your money is not affected by any external influences, but it also gives low returns. In contrast, investing could amount to higher returns, but your investments could be thrown into a whirlwind of market volatility. A universal investment strategy known as Dollar-Cost Averaging is a well-known method way to overcome market instability when you invest, placing you on the right track for a retirement fund in the future.
Dollar-Cost Averaging is a concept followed by many seasoned investors. It’s a simple idea to consistently invest a fixed amount into a stock or mutual fund at fixed and regular intervals. This way, investors will consistently invest in a stock or fund regardless of market changes, and thus it reduces the risk of buying at the peak.
The consistency in investing the same amount, at the same time intervals, no matter the market condition, generally pays off when you have a long investment horizon. Over time, this practice averages out the stock or fund prices, reducing your average cost per share. Provided your stock or fund picks are fundamentally sound, your investment will gradually grow and ensures a greater chance of building long-term wealth thanks to your consistent application of dollar-cost averaging principles.
The dollar-cost averaging principle goes hand in hand with the concept of “time in market is better than timing the market”. It means investing small amounts in the market is a better investment strategy than investing in lump sums. At times of market volatility, stocks that are below its net asset value (NAV) may go even lower than your entry price. If you invested in one lump sum, you will have no opportunity to further reduce your purchase price by buying more stock at the lower prices – but if you applied DCA principles, lower prices means you average down your purchase price, putting you in a better position to reap better returns when the market trends upwards.
As an example, Apple’s stock price in the last 12 months ranged from $173.30 to $327.20. By applying DCA during this 12-month period, you would have purchased the stock at consistently lower prices on average and ensure that you are not fully exposed to buying the stock at historical highs in January to February 2020.
That said, no matter what investment strategy you use, there is always the risk of making a loss. Even with DCA, you should always research the stock or fund that you are looking to invest in – there’s no point averaging down on a company with poor fundamentals or a fund that has historically done poorly. On top of that, market fluctuations are unpredictable and a bear market may last for years. Averaging down during a bear market may result in a longer-than-expected investment timeframe, which is why the next point is crucial before beginning any investment.
As much as dollar-cost averaging is a tried-and-trusted investment strategy, you should always lay the groundwork before starting an investment. Before starting any investment journey, it’s important to identify things such as investment goals as well as your investment timeframe. On top of that, another important question you must be able to answer is “how much can you consistently invest each month?”
To answer those questions, you’ll need to do some homework. It’s tedious, but this exercise is crucial to identify your financial wellbeing. How much do you spend every month on essentials like groceries, bills and other commitments, as well as dining out? On top of this, how much do you set aside for savings and for emergency? The balance should be a good indicator of how much you are able to invest every month. It’ll give you the knowledge that you have a specific amount set aside each and every month to go into investing, and the confidence that losing this amount will not leave you financially vulnerable. This makes it easier to apply dollar-cost averaging principles in your investments.
As you grow in your career, you should revisit this exercise. You should always save and invest more when your income increases.
Given the benefits of dollar-cost averaging, it is no surprise that this investment strategy remains widely used. Ideally, dollar-cost averaging should be applied across all your investments, from your safer investments to the riskier ones. Not only will you stay invested regardless of the market condition, but it also creates discipline to continue investing and not be tempted to use your savings for impulsive shopping or any other short-term ideas. It is simple to understand and implement, ensuring that your investment profits will financially prepare you for retirement.
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