Dollar-cost averaging is a popular and fruitful tactic that many investors use to lower their overall risk and boost returns over a long period of time. It’s pretty easy to do, too – so long as you’re a disciplined investor!
Dollar-cost averaging merely requires investors to make small investments over a wide time period. By doing so, you’re effectively buying assets at varying prices, since prices go up and down. Think of it this way: If you buy Stock A for $1 today, but Stock A’s price is $2 tomorrow, and you also buy one share tomorrow, you’ll have to shares of Stock A, that you purchased at two different prices.
So, what’s the average amount you paid for a share of Stock A, then? The answer is $1.50. Now, if Stock A’s prices shoots way up or way down over the course of many weeks or months, but you buy one share of Stock A every single day, regardless of its price, the average amount you paid per share is going to be more or less similar to Stock A’s overall price trajectory.
In other words: You won’t lose your shirt if Stock A’s price craters. Conversely, you won’t see massive returns if its price skyrockets. Remember, big returns accompany big risks. And dollar-cost averaging is, at its core, a risk-hedging strategy. You’re trying to lower your risk by doing it, so there are some trade-offs in terms of seeing potential massive returns.
This is also why it’s generally considered a good idea to keep on investing even if the market falls – you’re basically buying shares at a lower price, lowering the average amount you’re paying for them! It’s also why you should invest as often as possible.
A Dollar-Cost Averaging Example
Here’s an example of how dollar-cost averaging might look:
Again, we’ll use Stock A as our main security, and we’ll buy a single share of Stock A every day for ten days. Here’s a fictional record of our purchases, and the price we paid for our daily share of Stock A for each of the ten days:
- Day 1: $1
- Day 2: $3
- Day 3: $1
- Day 4. $0.50
- Day 5: $2
- Day 6: $5
- Day 7: $7
- Day 8: $5
- Day 9: $1
- Day 10: $0.50
Overall, we now own ten shares of Stock A, and we paid an average price of $2.60 per share. If we decide to sell our shares on a day when Stock A’s value is high, say around $7, that’s a pretty good return. But if we sell on a day when it’s $1, we’re losing money, but not as much as if we had bought ten shares on a day when its value was $7.
Again, dollar-cost averaging is supposed to be used as a long-term investing strategy, and to help smooth out the overall risk in a portfolio. Along with diversification, it’s one of the simplest, yet potent, tactics investors can use!
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