The old adage “Buy Low, Sell High” works great … if you have a crystal ball for every investment you make. In reality, no one can predict with absolute certainty the best time to buy or sell an investment. How do you know that a stock is at its lowest price when you buy? How can you tell that a stock price won’t climb higher after you sell? Stop stressing over things you cannot control. That is why you should remove one word from your investment vocabulary: timing.
Now replace that word with something else: dollar-cost averaging.
Dollar-cost averaging is a method of investing the same amount of money on a consistent basis, so that your overall price tag ends up an average rather than the highest point or the lowest point on the scale. Why does this work in your favor? Because you are investing the same amount of money each time, you’re buying more shares when the price is low. That’s smart! You managed to scoop up a good deal. And when the investment price goes up? You naturally buy less shares with the same amount of money.
Think of it like your favorite pair of pants. When they’re on sale, maybe you buy more than one pair. But when they go back to retail price, you stick to just buying one pair. The difference between investing and buying clothes is that with investments, nothing will advertise that they are on sale. That’s where dollar-cost averaging helps you out. This method automatically buys more at a low price.
How do you get started? Chances are if you have a 401(k), you’re already dollar-cost averaging. That is because you already apply the same amount on a regular basis to an investment. But you can do the same without a 401(k). If you have a sum of money, rather than investing it all at one time, consider dollar-cost averaging instead. Let’s use a sample stock purchase to illustrate this strategy.
Dollar-Cost Averaging Example
Investment Amount: $300 per month
Shares of Stock Purchased:
- January @ $10 / share = 30 shares
- Average price @ $10.00 / share ($300 paid for 30 shares)
- February @ $15 / share = 20 shares
- Average price @ $12.00 / share ($600 paid for 50 shares)
- March @ $20 / share = 15 shares
- Average price @ $13.85 / share ($900 paid for 65 shares)
- April @ $16 / share = 18.75 shares
- Average price @ $14.33 / share ($1,200 paid for 83.75 shares)
- May @ $15 / share = 20 shares
- Average price @ $14.46 / share ($1,500 paid for 103.75 shares)
- June @ $20 / share = 15 shares
- Average price @ $15.16 / share ($1,800 paid for 118.75 shares)
Remember when we talked about timing? Can you predict what the price of the stock will be next? You can try to guess, but would you bet all your money on it? Now you understand why timing the market is not such a great idea.
As you notice in the example, the actual price of the stock took a bumpy ride, sometimes jumping $5 up or down between months. But thanks to dollar-cost averaging, you enjoyed a much smoother ride, with the biggest swing being a $2 difference in average price between January and February. Most people cannot pay every second of attention to investing, let alone stomach the bumpy ride. Dollar-cost averaging makes for a much smoother ride. If you were on a roller coaster, wouldn’t you want one with smooth turns, rather than jagged cliffs? That is why smart investors choose dollar-cost averaging!
Homework: Make dollar-cost averaging a new year’s resolution, whether it be through a 401(k) or an investment account. Consider tracking the average price paid per share every month for the next 6 months to see how dollar-cost averaging works.
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