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Topic: How To Invest

What is a dollar cost averaging strategy?

dollar cost averaging strategy

Using a dollar cost averaging strategy is one of the best systematic ways to make money in the stock market.

A dollar-cost averaging strategy involves investing equal amounts of money over a specific period ($200 a month, say).

It’s a little like systematic saving, except that you put your money into stocks (or ETFs) instead of a bank account.

Using a dollar-cost averaging strategy helps build consistent long-term retirement investing returns: Long-term studies show that the stock market as a whole generally produces total pre-tax annual returns of 8% to 10%, or around 6% after inflation. Over periods of a few years or less, the return is far more variable and always uncertain. The surest way around this uncertainty is to start practicing dollar-cost averaging as early as possible, and invest regularly over the course of your working years. Then you can sell gradually in retirement.

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Using a dollar-cost averaging strategy largely frees you from stock market trends: In fact, if you invest a fixed sum at regular intervals throughout your working years, perhaps increasing that sum from time to time as your income rises, you can largely forget about market trends. That’s because you’ll automatically buy more shares when prices are low and fewer when they are high, and you will benefit from the long-term rising trend in the market.

Let’s look at an example: Let’s go back to January 2, 2005. Say your employer paid you an annual bonus of $1,000, and you created a dollar-cost averaging program that involved investing this money every year in shares of ACMEbank. On January 2, 2005, ACMEbank shares closed at $20.58 (all share prices adjusted for a 2-for- 1 split on April 1, 2011.)

Over the following years, ACMEbank shares rose as high as $54 (in 2007), fell as low as $24 (in the market downturn of 2009), and rebounded to $56.29 on January 4, 2015, when you would have made your latest purchase.

However, thanks to dollar-cost averaging, you would’ve bought more ACMEbank shares when they were low and fewer when they were high. So, if you bought ACMEbank shares on the first trading day of every year from January 2005 through January 2015, your average cost would have only been $39.33 a share.

Let’s say on January 4, 2015, ACMEbank was trading at $56.29. If you had followed our dollar-cost averaging strategy, you would be ahead by $16.96 a share, or 43.1%.

Note that this gain doesn’t include dividend payments, which have risen significantly over the past 10 years.

What are dividends?

Dividends are typically cash payouts that serve as a way companies share the wealth they’ve accumulated through operating the company. These payouts are drawn from earnings and cash flow and paid to the shareholders of the company. Typically, these dividends are paid quarterly, although they may be paid annually or monthly as well. Note that dividends can produce as much as a third of your total return over long periods.

Have you used a dollar cost averaging strategy before? Have you found it profitable? Share your experience with us in the comments.



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