Most investors have a goal of buying an asset at a low price and selling it later at a higher price. The problem is, during short periods of time, it's nearly impossible to predict those types of price fluctuations.
Instead of focusing so much on trying to identify the best time to invest in the stock market, experts recommend regularly buying assets at set intervals, a strategy known as dollar-cost averaging.
This strategy helps smooth out the amount you pay for an asset, ensuring that you don't invest all your money when the stock market is at a record high, for example. During periods of bumpiness, dollar-cost averaging also helps investors to take advantage of lower prices.
Here's what you need to know about dollar-cost averaging, and why it's a prudent strategy for long-term investors.
How dollar-cost averaging works
If you have a 401(k) or other workplace retirement plan, you're most likely dollar-cost averaging, even if you don't realize it. That's because contributions to these accounts are generally made every pay period with whatever cadence your employer pays you.
If you're investing outside of your 401(k), say in an IRA or in a taxable brokerage account, it's smart to consider using a similar strategy. That's because you'll benefit from the natural fluctuations in the market and you have the potential to lower the average cost you pay for an investment.
By setting a regular schedule — like each Friday, every other Tuesday or the second Wednesday of each month — you will invest the same amount of money, no matter whether the market is up or down that particular day. Doing so simplifies the investing process, it removes the temptation to try to time the market (predict when prices will be higher or lower), and it removes any potential emotional bias.
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How dollar-cost averaging compares to lump-sum investing
Consider that you want to buy $1,000 worth of an index fund that tracks a broad market benchmark, like the S&P 500. The two primary ways many people might invest that money are:
- Lump-sum investing. With this strategy, you'll buy $1,000 worth of the exchange-traded fund (ETF) and your cost basis for this investment would be the price you paid.
- Dollar-cost averaging. With this strategy, you'll instead spread out your $1,000 investment, say in $200 increments. As a result, you'll buy at potentially five different prices.
Even in a bull market, defined as a period of steadily rising stock prices, some fluctuation is normal. In fact, declines of at least 10% from a prior high for a major benchmark like the S&P 500 are pretty common.
During the 2010s, the U.S. stock market endured six such corrections, and these types of market sell-offs happened less often in the past decade than you might expect. Going back to 1928, Bespoke Investment Group calculates the average occurrence of a correction of at least 10% to be a little more than once a year.
In theory you might buy at the lowest possible price with lump-sum investing, but that's rarely how the market works — and not the type of good fortune most investors have.
With a dollar-cost averaging strategy, you'll take advantage of those normal price fluctuations in the market. For example, if a fund trades between $95 and $105 during that time, you'll be able to buy more shares when the price is low, and fewer when the price is higher.
Which strategy is the winner? An immediate lump sum investment in the U.S. market has outperformed a dollar-cost averaging approach over a 12-month period by nearly 2.4 percentage points, according to research conducted by Vanguard. And the likelihood of this strategy outperforming increases when there's a longer period of time for the systematic investing approach.
However, the research shows, dollar-cost averaging minimizes the potential for regret. And it's rare that most people will come upon the kind of windfall that might make a lump-sum investment attractive. That's why experts recommend that instead of accumulating a set amount to invest, like $1,000, all at once, you start sooner and with smaller increments.
How to make investing into a habit
The process of defining a set investing schedule is an important piece of forming a habit, which is key if you want to keep growing your wealth. When investing is a habit, then, whether the market's on the upswing or heading temporarily lower, you'll keep adding money to your portfolio and benefit from watching that wealth compound.
Automating the saving and investing process can also help people to save more money for long-term goals like a comfortable retirement. Habits like this are among those favored by "supersavers" who get close to the annual 401(k) contribution limit, even though 48% earn less than $100,000.
Finally, dollar-cost averaging is an important way to keep plugging away at your long-term goals and remain consistent with your investment strategy.
The article Dollar-cost averaging: One strategy for long-term investing success for originally appeared on Grow by Acorns + CNBC.