Dollar-cost averaging is a strategy that may provide some protection to your retirement savings against short-term market fluctuations. In contrast to market-timing strategies, dollar-cost averaging helps you steadily accumulate investments without trying to predict market fluctuations.
Dollar-cost averaging is the act of buying shares of an investment with the same amount of money on a periodic schedule so that the number of shares may fluctuate from period to period, but the amount invested does not. This way, you may buy some shares at a higher price, and some at a lower price, over time. Dollar-cost averaging thereby averages out your overall cost and shields you from investing a lump sum during an inopportune time in the market.
Contributions to a 401(k) plan are a form of dollar-cost averaging: you’re using a predetermined portion of your paycheck each pay period to purchase the same allocation of fund shares, regardless of the market price.
An example of dollar-cost averaging
Peter Planner decides to buy $1,000 of Organic Orangutan Oculars (OOO) stock each month for 4 months beginning in January. OOO shares decline for the first 3 months, but then rebound in April.
After making consistent $1,000 purchases over 4 consecutive months, Peter owns 201 shares in OOO. His average price per share is approximately $19.90 ($4,000/201 shares). OOO’s share price is $22 at the end of April, which is higher than Peter’s average price per share of $19.90. So, despite the share price dropping from $25 in January, Peter still makes a profit of $422 at the end of April.
Dollar-cost averaging works best with investments that do not charge a transaction fee, meaning there is no fee for buying or selling an investment. By utilizing dollar-cost averaging, you’re able to put your investments on autopilot and watch your savings grow over time.
This information is provided for informational purposes only, and is not intended to be construed as investment advice. Consult a qualified financial advisor to determine the appropriate investment strategy for you.