If fear of the market keeps you up at night, one of the best and most effective ways to take advantage of any market event, good or bad, is to consider using an investment strategy called dollar cost averaging. You can automate this method to force you to invest on a regular basis regardless of market conditions.
With dollar cost averaging, you invest the same dollar amount at regular intervals over time. By consistently following this strategy, you may be able to reduce the impact of market fluctuations on your investment portfolio.*
For example, let’s say that you decide to invest $300 each month toward retirement. As the following illustration shows, you automatically buy more shares when prices are low and fewer shares when prices are high:
Your regular monthly investment of $300 bought more shares when the price was low and fewer shares when the price was high. The result? The average cost of the shares you purchased is less than the average market price per share over the period.
Dollar cost averaging is often favored by those who wish to make their periodic investment a part of their monthly budget. The amount invested each month is predictable. An automatic investment plan ensures that the predetermined amount is properly invested at appropriate intervals. Among other things, this relieves you of the concern and emotional burden that comes with trying to decide when, and how much, you should be investing when the price of your securities is rising or falling. Experts suggest that this strategy works best with a single investment vehicle that regularly fluctuates in price.
Remember that since dollar cost averaging involves continuous investment in securities regardless of those securities’ fluctuating prices, you should consider your ability to continue purchases through periods of low price levels. Also, all investing involves risk, including the possible loss of principal, and there can be no guarantee that any investing strategy will be successful.
Making dollar cost averaging work for you by:
- Starting as soon as possible. The longer you have to ride out the ups and downs of the market, the more opportunity you have to build a sizeable investment account over time.
- Stick with it. Dollar cost averaging is a long-term investment strategy. Make sure that you have the financial resources and the discipline to invest continuously through all types of markets, regardless of price fluctuations.
- Take advantage of automatic deductions. Having your investment contributions deducted and invested automatically makes the process easy and convenient.
The best way is to use payroll deduction/bank authorization to fund your investment program. If you want to invest gradually over a period of time, you can authorize your employer or bank to send a specified amount of money at specified intervals automatically to your investment broker. That way, investing becomes convenient and automatic, making it easier for you to pursue your goals.
The advantage is that it makes regular investing easy. You can use automatic payroll deduction or bank authorization to implement a periodic investment approach, such as dollar cost averaging.
Periodic investing is a strategy whereby you make regular investments on a monthly, quarterly, or yearly basis. The plan has a set pay-in period and a mechanism to withdraw funds from the plan after that time.
There are several forms of periodic investing, but they all have the same goals: (1) to make investing automatic and eliminate the need to “time” the market, (2) to help smooth out market price fluctuations, and (3) to reduce the risk of loss during a downturn in the market.
It also minimizes the temptation to spend money elsewhere. Using payroll deduction or bank authorization can help you save money because you won’t be tempted to spend it elsewhere.
The easy part is how to do it. Most employers who offer qualified retirement plans allow you to contribute through automatic payroll deduction. Some employers also allow employees to contribute to personal savings accounts and/or investment funds. An employer also may enable you to purchase electronic U.S. savings bonds through a payroll savings plan (though you must first set up a TreasuryDirect account). Setting up automatic payroll deduction is usually as simple as contacting your employer and filling out paperwork that authorizes the transaction and specifies the amount to be deducted each pay period.
If you want to transfer funds directly from your bank account to your investment program, you must also authorize the transaction. Contact your bank and/or broker to find out the procedure.
Tip: Many brokerage houses and large mutual fund companies also offer accounts and services similar to those at banks, so you may be able to have earnings from one account automatically transferred to fund another type of investment.
If you want to buy an individual stock, you may have the options of participating in a dividend reinvestment program (DRIP). A DRIP automatically reinvests your shareholder dividends in more shares of the same company’s stock. When you are due a dividend, you are issued more shares of stock instead of a cash dividend payment. In some cases, the issuing company will cover the broker’s fees and may even provide the additional shares at a discounted price. That means you get more bang for your investment buck. These plans allow companies to raise capital without conducting a new public offering of securities.
In addition to those bonuses, you benefit by accumulating shares in the company automatically and incrementally over the long term. In that regard, DRIPs have advantages similar to those provided by automatic investment plans. Periodically, a portion of your income (in this case, dividend income) is automatically invested without the need for you to make a separate investing decision each time.
DRIPs also have some advantages similar to those of dollar cost averaging plans. Your investments are made periodically so that you can take advantage of fluctuations in the market and hopefully achieve an overall lower average share price than if you made a one-time investment at the wrong time. Remember, to achieve the advantages of a diversified portfolio, you do not want to invest all of your savings in only one DRIP. By investing in a number of DRIPs offered by different companies in various industries, you can reduce your portfolio’s exposure to the risk that shares of one of the companies will decline in value.