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Dollar-cost averaging: How to use the strategy to build wealth over time

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Dollar-cost averaging is a simple investment technique that can increase your returns without added risk. It is particularly useful for those who prefer buy-and-hold investing and want to manage their investments less frequently. This investment strategy is both powerful and straightforward, making it an excellent option for individual investors. To maximize your gains, learn more about dollar-cost averaging and how to use it.

What is dollar-cost averaging?

Dollar-cost averaging means investing a fixed amount of money on a regular basis, usually monthly or bi-weekly. If you have a 401(k) retirement account, you are already using dollar-cost averaging by adding to your investments with each paycheck.

Dollar-cost averaging is a strategy where you spread your buy points over time instead of timing the market. Timing the market can be risky if you invest all your money at once and the stock hits its high point, which could lead to a significant loss if the stock falls. With dollar-cost averaging, you’ll buy over time, which will average your purchase prices.

Regularly investing a fixed amount of money using the dollar-cost averaging strategy can benefit you in a volatile market. You can purchase more shares at lower prices, which reduces your average purchase price. Even if the market goes up, your prior purchases will balance out the lower number of shares your regular contribution can buy.

In addition, dollar-cost averaging has additional advantages. When stock prices drop, people tend to panic and stop purchasing stocks to avoid incurring more short-term losses. However, by establishing a regular buying plan during calm market periods, you can avoid this psychological bias and profit from lower stock prices when others become afraid.

You can increase your stock shares by reinvesting your dividends and apply the dollar-cost averaging principle to quarterly payouts. This allows you to convert your cash dividends into more stock shares over time. The setup process is all you have to do, and you’ll gradually earn dividends on your dividends.

Setting up a reinvestment plan requires a small initial time investment, after which you can put it on autopilot and have your broker take care of the rest. This is an ideal option for individual investors who want to minimize the amount of time they spend managing their investments.

Does dollar-cost averaging really work?

Investing using the dollar-cost averaging method has been a successful strategy for many people over time, although effectiveness can vary depending on your individual circumstances. Rather than attempting to time the market based on conditions, it is often more beneficial to consistently invest using this method. Trying to predict market trends has proven to be challenging, so having a reliable investment plan can lead to more success.

If you have a regular income and invest through a workplace retirement plan, dollar-cost averaging is a good strategy. This means investing your available money as soon as possible. But, if you inherit a large sum, such as $100,000, it’s not a good idea to invest it slowly over several years. Instead, it’s best to invest it quickly, but you can still spread out your purchases over a few months to benefit from possible market fluctuations.

Disadvantages of dollar-cost averaging

Dollar-cost averaging can be a disadvantage when the market continually increases over time, as being fully invested as soon as possible can potentially yield better results. However, as most people save and invest gradually, dollar-cost averaging is a good alternative.

Another drawback is that selecting sound underlying investments is still necessary. If you are gradually purchasing a weak investment, the method of purchasing will not rescue you. This strategy is most effective when used with diversified funds like the S&P 500 index fund, which has shown strong performance over extended periods of time.

How to dollar-cost average

There are two methods to establish dollar-cost averaging for your account: manual and automatic. If you choose the manual method, simply select a regular date, such as monthly or bi-weekly, and purchase the stock or fund through your broker. Afterward, you’re finished until the next date.

Setting up automatic buying may appear daunting, but it’s really quite simple. If you choose to automate your buying, it may take a little more time initially but will simplify things later. It also helps during market declines, as you won’t have to take any action.

Bankrate provides reviews of major players who offer automatic buying plans. Look for brokers that have additional features, such as excellent customer service and educational tools.

Here are the steps to make dollar-cost averaging fully automatic.

1. Choose your investment

To clarify, before making a purchase, it’s important to decide whether you want to buy individual stocks, an exchange-traded fund (ETF), or a mutual fund.

  • Buying an individual stock can result in higher fluctuations compared to a fund. However, finding a brokerage that allows automated purchases of stocks may be challenging.
  • Buying a fund will result in less fluctuation compared to an individual stock and more diversification; hence if any single stock in the fund declines, it won’t hurt you as much.

Less experienced investors often choose to invest in funds. One of the most diversified funds is based on the Standard & Poor’s 500 index, which includes hundreds of companies across major industries. This index is commonly used for creating a diversified investment portfolio. If you are interested in investing in an S&P index fund, here are some of the best options available.

Regardless of your option, it is important to take note of the ticker symbol for security. The ticker symbol serves as the abbreviated code for the stock or fund.

2. Contact your broker

After selecting your desired investment, check with your broker to confirm if you can establish an automatic purchase plan for that investment. If it is possible, then you can proceed to the next step.

If a broker only offers automatic investment plans for mutual funds, you could explore opening another brokerage account that caters to your preferences. Aside from this, having multiple brokerage accounts can offer additional benefits, and it is often a wise decision to have more than one account for a better investment experience.

3. Determine how much you can invest

Once you have a broker who can carry out your automated trading strategy, you need to determine the amount of money you can invest regularly. It is recommended to keep your money invested in any type of stock or fund for at least three to five years.

To account for the stock market’s frequent fluctuations, it’s advisable to give the investment time to develop and recover from any temporary drops in value. This implies that during that period, you must support yourself solely with your available funds that haven’t been invested.

First, determine how much you can allocate for investing based on your monthly budget. Once you have established an emergency fund, consider the amount of money you can invest without needing it immediately. Remember, it’s crucial to start investing regularly, even if the initial amount is not significant.

Nowadays, dollar-cost averaging has become more affordable because major brokers no longer charge commission fees on stock and ETF trades. In addition, the best brokers for mutual funds enable you to avoid fees for thousands of mutual funds. As a result, you can start investing with any amount of money to build your savings.

4. Schedule your automatic plan

To create an automatic trading plan with your broker, provide them with the stock or fund’s ticker symbol, the amount you want to purchase regularly, and how often you want the trade to happen. The procedure may differ depending on the broker, but these are the essential details required for the setup. In case of any doubts, seek assistance from your broker.

Setting up automatic dividend reinvestment with your broker when your stock or fund pays dividends can be a smart move. By reinvesting the dividend, you can start earning dividends as soon as the next payout. This way, any cash dividends will be used to buy new shares, including fractional shares. This puts the entire value of the dividend to work instead of leaving it sitting in cash and earning little to no interest.

Bottom line

Dollar-cost averaging can help reduce your investment risk and increase your returns in the volatile stock market. You can automate the purchase of stocks or funds through your brokerage account and enjoy the benefits of passive investing, allowing you to pursue other interests while investing. It’s a straightforward approach that can deliver superior results with minimal effort.

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