The pros and cons of cost averaging
OWhen it comes to investing, you have to ask yourself whether to invest the funds all at once or over a given period. If you choose the latter route, you could opt for an investment strategy called cost averaging.
With cost averaging, you invest your money equally, at regular intervals, regardless of the ups and downs of the market.
Let’s say you receive a bonus or have saved $10,000 to invest. Instead of investing this amount all at once, with an average purchase in dollars, you can divide this $10,000 into 10 parts and invest $1,000 per month for 10 months.
You may already be doing dollar-cost averaging without even knowing it. If you have a 401(k) plan or another type of defined contribution plan, your contributions are allocated to one or more investment options on a regular and fixed schedule, regardless of market movements. Each time this happens, you make an average purchase.
Before you start allocating your money, here are three things to know about average purchase price:
Why would someone consider a buying average?
It would be great if we could buy stocks or other types of investments when the market is low and sell when the market is high. Unfortunately, efforts to “time the market” often fail, and investors end up buying and selling at the wrong time.
When stocks go down, people often get scared and sell. Then, when the market rallies, they could miss out on potential gains. On the other hand, when the stock market goes up, investors might be tempted to rush. But they might end up buying just as stocks are about to fall.
The cost average can help eliminate the emotion associated with investing. This forces you to keep investing the same (or nearly the same) amount regardless of market fluctuations, potentially helping you avoid the temptation to time the market.
When you average dollar purchases, you buy more shares of an investment when the stock price is low and fewer shares when the stock price is high. This may result in the payment of a lower average price per share over time.
And by wading, instead of handing over your money all at once, cost averaging can help you limit your losses if the market goes down.
What are the potential downsides of cost averaging?
The cost average can be a useful tool to reduce risk. But investors who engage in this investment strategy may lose out on potentially higher returns. With cost averaging, you keep your money in cash for longer, which is less risky but often produces lower returns than a lump sum investment, especially over longer periods of time.
If the market rises during a period when you are averaging, you risk missing out on the potential gains you could have made had you invested right away in one fell swoop.
Of course, this doesn’t apply to something like your 401(k) because in that situation you invest the money as you earn it, and don’t keep cash until at a later date.
Also, keep in mind that if you engage in recurring fixed-money purchases, you may incur higher brokerage fees. These fees could erode your returns. And you also have to be disciplined with that money that sits on the sidelines in order to eventually invest it and not erode it with purchases.
What is the net result for investors?
As with all aspects of investing, it’s important to consider potential returns as well as your risk tolerance.
Investing all your money right away can generate higher returns than putting in smaller amounts over time.
But if you’re looking to reduce your risk and control your emotions, or are concerned about volatile market conditions, cost averaging could be a viable strategy, even if it means giving up some potential benefits. If your main concerns are to reduce the risk of short-term loss and avoid feelings of regret after a potential loss, the cost average might be right for you.
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