Taking the guesswork out of how much and when to invest can help a new or anxious investor find a foothold in the markets. For these folks, a dollar-cost averaging approach can make sense. But what is dollar-cost averaging, when should it be considered, and what are some potential pitfalls of this investing tactic?
In simple terms, dollar-cost averaging is the practice of investing a fixed dollar amount into a security or investment strategy on a regular basis, regardless of share price. For many individuals, it's a good way to develop a disciplined, efficient investing habit without worrying about timing.
Dollar-cost averaging is often encouraged when market volatility feels elevated, as it can help manage investor emotions and avoid rash decision making. It can also help an investor to redeploy cash into investments when they’ve become restrained by fear of uncertainty.
In addition, dollar-cost averaging can be more effective in taxable accounts where cost basis will determine potential future taxable gains and investment time horizons can be shorter than retirement-focused vehicles. Investors often naturally spread out investment purchases within retirement plans and IRAs through periodic contribution throughout the year. Dollar-cost averaging could also be utilized in the case of a large retirement plan rollover when market volatility is high.
That’s not to say there aren’t potential drawbacks to a dollar-cost average approach. One of the biggest is an investor second-guessing the decision. Depending on how the market performs after implementing the plan, an investor might wish they had invested more before a price increase or perhaps invested less if the investment has experienced a decline. The key to mitigating this knee-jerk reaction is to agree on the specifics of the approach at the outset and for investors to be reminded that this is part of averaging the purchase price.
Implementing a dollar-cost averaging plan can help some investors find the confidence to make the move to invest for their future. If you have questions or would like to learn more, be sure to talk with your RMB advisor.