Rather than fear market volatility, why not take advantage of dollar cost averaging to try improving your long-term returns?
There is a simple investment system known as “dollar cost averaging,” that is utilized automatically by many of the millions of Americans who contribute regularly to 401(k) or other retirement accounts through payroll deductions. The strategy has been used for many years by investors who are seeking to generally capitalize on the ups and downs of the market.
With dollar cost averaging, investors simply invest a set dollar amount in the stock market (typically through broadly diversified mutual funds) on a consistent periodic basis no matter where the market stands nor how great the volatility.
Dollar cost averaging requires virtually no effort or expertise on your part – yet may help you improve your returns in spite of volatile markets by buying more shares when the market is down and fewer shares when it’s up. While the success of the strategy is aided by an upward trend of the market, dollar cost averaging would not likely improve the performance of an investment that continues to fall in value. (Periodic investment plans do not ensure a profit or protect against a loss in a declining market.)
The basis of the strategy is simply a matter of mathematics. When you invest a set amount each month, that static dollar amount buys more shares when the market is down and prices are cheap, and buys fewer shares at the peak of the market when prices are the highest.
In a market that is trending upwards, the shares you bought at below average prices may help tilt your long-term performance to a slightly higher return.
The chart below gives a hypothetical example of the investment impact of dollar cost averaging:
As the table illustrates, the average fund price during the period was $100, but the average price of the fund shares purchased through dollar cost averaging was only $97.50 ($12,000 ÷ 123.1 total shares). As a result, the investor was able to purchase an additional 3.1 shares.
That would be a positive difference of $310.
To put it another way, although the fund price was the same at the end of the year as it was at the start of the year, the investor’s $12,000 investment would have been worth $12,310 at the end of the year – a 2.6 percent gain attributed entirely to dollar cost averaging.
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