You want to start or start investing again in your New Year’s resolutions, but the fall in the stock market makes you nauseous for fear of losing all your savings.
The cost average (DCA) is a good way to facilitate investing. Instead of trying to time the market and investing all your money at once (lump sum investing), the DCA strategy involves buying a fixed amount of a particular investment, such as an ETF or mutual fund , on a regular schedule.
Averaging can provide better returns in a falling market than a lump sum investment, reducing the risk of buying a huge amount of a mutual fund or ETF at the wrong time. Keep in mind that DCA only works if you have a long-term investment horizon, regardless of market direction.
Here’s how it works. In a falling market, let’s say you invest $25,000 each quarter in a mutual fund or ETF for the entire year. Because you buy at different prices, you buy more shares when prices are low and fewer shares when prices are higher. In this way, the average cost of the shares of the purchased fund becomes lower and lower. In this example, you purchased a total of 1,197 shares, with an ending value of $83,811. If you had invested the entire $100,000 lump sum in the first quarter, you would have owned 1,000 shares, with an end value of $70,000.
In a rising market, the reverse is true. By investing $100,000 at once in Q1 at $100 per share, your money would have grown to $140,000 in Q4, when the stock price reached $140. In this scenario, the purchase average grew more slowly than the lump sum investment, bringing in only $116,088 at the end of the year.
No investment strategy is perfect or foolproof. Overall, DCA helps you lose less money in a falling market, but won’t make you as much money in a rising market. For novice investors, cost averaging can help you build wealth with less risk.
Don’t set it and forget it. Although fixed sum investing is automatic, check it regularly to make sure you’re investing in the right funds based on your investment plan, time horizon and risk tolerance.