Dollar cost averaging is a popular investment strategy that involves investing a fixed amount of money at regular intervals, regardless of the price of the asset being purchased. The goal of this strategy is to reduce the overall risk of investing in volatile markets by averaging out the cost of the asset over time.
One way to understand how dollar cost averaging works is through an example. Let’s say you have $1,000 to invest in a mutual fund and you decide to use a dollar cost averaging strategy. Instead of investing all of your money at once, you decide to invest $100 every month for 10 months.
In the first month, the price of the mutual fund is $10 per share. You buy 10 shares for a total cost of $100. In the second month, the price of the mutual fund has increased to $12 per share. You still invest $100, but this time you only buy 8.33 shares. In the third month, the price of the mutual fund has decreased to $8 per share. You again invest $100, this time buying 12.5 shares.
This process continues for the remaining seven months, with the price of the mutual fund fluctuating up and down. By the end of the 10 months, you have invested a total of $1,000 and bought a total of 50 shares in the mutual fund.
If you had invested all of your money at once, you would have only been able to buy 100 shares if the price was $10 per share or 50 shares if the price was $20 per share. However, by using a dollar cost averaging strategy, you were able to buy 50 shares at an average price of $20 per share, which is a more favorable outcome in a volatile market.
Overall, dollar cost averaging is a great strategy for investors who are looking to minimize their risk and average out the cost of their investments over time. It can be particularly useful for those who are investing a large lump sum of money or who are new to investing and may not feel comfortable making a single large investment.