If you inherited a large sum of money unexpectedly, what would you do with it?
Purchase your dream home? Send your children to college debt-free? Embark on a luxurious retirement?
We all have dreams that we’d make reality, if only money weren’t an issue. Most of us, however, won’t be lucky enough to receive an unexpected sum of money able to fulfill all of our wishes. Instead, we must pursue our goals a different way—by consistently investing a portion of our income. Unlike receiving an inheritance, investing comes with some risk. But there’s a simple way to harness the volatility of the market and turn it to our advantage.
Dollar Cost Averaging
Dollar cost averaging is the practice of investing an equal amount of money at regular intervals, regardless of whether the market is up or down. Not impressed? Hear me out. The genius of dollar cost averaging lies in its simplicity. By investing the same amount every month, you are guaranteed to automatically buy MORE shares when prices are low and FEWER shares when prices are high. To better understand the considerable advantages of doing so, take a look at this graph depicting a hypothetical investing scenario:
Notice how many more shares our hypothetical investor –we’ll call her Mary –buys when prices dip to $2 per share than when the price rises to $10 per share? The result, as you can see in the accompanying table, is that Mary’s average cost per share –$4.38 –is markedly lower than the average price per share –$6.00 –over the period in which she was investing. What does that mean in terms of dollars and cents? Let’s do the math. At the end of 11 months, Mary has accumulated 685 shares that are worth $6.00 each. That’s $4,110, a handsome profit on her $3,000 investment, despite the fact that the price per share at the end of 11 months was exactly where it began.
It’s important to offer a couple of caveats here. First, this hypothetical scenario dramatically exaggerates the short-term volatility of a typical investment in order to illustrate the concept of dollar cost averaging. Second, dollar cost averaging is not magic. No matter how many low-priced shares you buy, you’ll only earn a profit if the price of those shares eventually rises.
Taking the Emotion Out of Investing
But the fact remains that dollar cost averaging is an excellent way for most people to invest for their long-term goals. It effectively removes the emotions that cause so many investors to buy high and sell low from the equation. And by dollar cost averaging via a monthly allotment or bank draft, you can capitalize on yet another time-tested investing method: paying yourself first.