If you have a significant amount of money invested in stocks, you likely keep a pretty close eye on what the market is doing. When it goes up, you have a positive feeling about continuing to contribute money to equity investments. However, when stocks go down, it can make you want to pull your money out quickly. If these emotions get the better of you, it can lead to strategic decisions that in the end have a very damaging effect on your investments.
Think of it like this:
Let’s say you want to invest in an index fund – an investment product that seeks to reflect the general movements of the stock market as a whole. After completing your budget you decide that you have $100 to invest each month in the index fund. You invest your first $100 on January 1st. At the end of the month, the stock market has gone up significantly and you see a nice gain in the value of the index fund. This goes on for the 2 following months and you continue to invest your $100 each month. But at the end of April, you notice that the value of your investment in the index fund has actually dropped over the preceding month. Afraid of the direction the market is taking, you decide not to invest that month. When at the end May your index fund goes down again, you withhold investing any more money to wait and see what the market is going to do. After a solid June for the market, you start to invest your monthly $100 in the index fund again.
The net effect with this kind of approach is that you consistently buy stocks when they are relatively high-priced and then abstain from buying them when they are priced lower. Using this method will mean that the average price of the stocks you have bought will always be higher.
Now let’s say that instead of trying to “chase the market,” you adopt a policy of dollar cost averaging. This means that when beginning an investment strategy, you decide on a period of time for which you will commit a consistent amount of money to be invested at regular intervals. Using the same example of $100 set aside for investing in an index fund each month, you would buy 4 shares when the index fund is trading at $25 per share. If the index fund drops to $20 per share, you would buy 5 shares since you have committed to investing a set amount of money – $100 – instead of investing a varying amount based on the price of the investment product. If the index fund goes up to $50 per share, you would only buy 2 shares. In this scenario, at the end of the period for which you have set up your dollar cost averaging strategy, the average cost of your investment is lower because you have bought more shares when the price was lower.
Using dollar cost averaging is a way to take a “bigger picture” approach to your investing that can in the end give you much better value for the money you have invested and help you avoid the pitfalls of reactionary investment choices.