As financial experts warn about the threat of a recession, everyday investors might wonder what the best course of action is to avoid big losses.
That's where dollar-cost averaging comes in to play. Dollar-cost averaging is a strategy in which people invest the same amount of money at regular intervals (say, each pay period). It ensures that investors aren't just responding to their emotions by selling high and buying low. Instead, they contribute the same amount of money no matter what prices stocks are listed at.
"Investing in the S&P over the last 20 years produced an annualized return of 7.2%, but missing just the top 10 days in those 20 years cuts the return in half, to 3.5%," writes CNBC "On-Air Stocks" editor Bob Pisani. Dollar-cost averaging means investors aren't missing out on those top 10 days if they get spooked during a downturn.
The good news is if you contribute to a workplace retirement plan like a 401(k) or an individual retirement account each month, you're already following this strategy and benefiting from it.
"If you're enrolled in a 401(k) plan at work, don't stop contributing," Janet Alvarez, personal finance expert at Wise Bread and CNBC contributor, tells CNBC Make It. "It's essential to buy stock on the way down, just as you do on the way up."
It's especially useful during a market downturn, because while an investor's reaction might be to stop investing until the market starts climbing again so you don't lose money, the better strategy is to buy at the lower price. But it's essentially impossible to time the market effectively over the long term, so dollar-cost averaging evens out the bumps so that investors come out ahead.
"I try to tell my clients to fund their Roth IRA accounts each month to take advantage of this time-tested strategy," Ryan J. Marshall, a New Jersey-based certified financial planner, tells CNBC Make It. "Dollar cost averaging helps avoid 'market timing' at the wrong times."
This investing strategy also helps take emotion out of the equation, Marshall adds.
"More specifically, it helps clients not see as sharp of a decline on their statements during periods of pullbacks because they are adding money each month," he says. "Most clients look at the bottom line on what the value was last month versus what is the value this month."
If you're already investing are regular intervals, then your best course of action is to keep contributing the same amount, no matter what the market does. Let dollar-cost averaging do the rest.
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