What Is Dollar Cost Averaging?
What is it? Dollar cost averaging is the practice of regularly investing a fixed amount of money regardless of market activity. This strategy lowers the average cost per share of an investment and eliminates the risk of a single investment at the wrong time.
Stay with me! Sounds complex but in practice it’s really simple: put aside the same amount of money every week (or month) and don’t stop.
Of course, in an ideal world, we would buy stocks at a low price and sell them at a high price – but turns out this is not an easy thing to predict. We (humans) tend to get it wrong.
How, exactly, does investing regularly lower the average cost of an investment?
Consider this simple case – for the past two years, someone invests $1,000 per week in the S&P 500, for a total investment of $104,000. At the end of the two years, they own 85.6 shares, which are worth $117,638, a return of about 13%.
Now, imagine that this money had instead been invested all at once. Let’s look at a few random dates, say the birthdays of some of the Betterment team:
|Kiran||Thursday, March 01, 2012||1365.9||$104,623|
|Alan||Friday, February 17, 2012||1358.06||$105,227|
|Brittany||Monday, February 13, 2012||1343.06||$106,402|
|Sarah||Wednesday, January 25, 2012||1314.4||$108,722|
|Anthony||Thursday, September 22, 2011||1164.55||$122,712|
|Edwin||Monday, April 04, 2011||1333.56||$107,160|
If Anthony invested the money on his birthday last year (Sept. 22), he would have gained more than the dollar cost average example – happy birthday Anthony! But in every other case the end value was lower, and there’s really no way of predicting the rare occasions the value will be higher.
When prices are low, your money buys more shares, and when prices are high, your money buys less. The important thing is that the average cost per share and your exposure to risk will be lower if you invest regularly.
Why it Matters
In addition to averaging out the cost per share and lessening risk, dollar cost averaging has other benefits: By investing on a set schedule, you avoid the impossible task of trying to time the market. Regardless of market activity, your investment increases, and over time, so will your returns.
How it Works in Betterment:
For dollar cost averaging to be effective, you must regularly purchase shares and continue to do so over time. This will eventually drive the average cost per share down to lower and lower levels.
Betterment’s auto-deposit makes this really simple, and unlike other brokerage accounts, Betterment charges nothing for trades or transfers. Set up a weekly or monthly auto-deposit in your Betterment account and the money will be seamlessly transferred out of your checking and into your investment account.
Balance Risk & Reward:
While you want to avoid the risk of investing at a bad time, you must balance the trade off between risk and reward. In most cases, keeping a large amount of money out of the market is not the right approach to take. In cases where you have a large amount of liquid cash, it may make more sense to invest it at a faster rate, especially with the paltry returns you’ll get from a savings account. Then, keep supplementing regularly to get the benefits of dollar cost averaging. As always, having a good sense for your risk tolerance and timeline is key.
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I’ve been asked a lot in the last few months in the transition from my old role at Vanguard to my new role as Chief Growth Officer at Betterment – what’s the difference between the two companies?
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