Reduce market risk with dollar cost averaging

Author: Steven posted in Investing basics tagged with Investing 101

Dollar cost averaging explained

When buying stocks at predetermined time intervals and set dollar amounts you are performing dollar cost averaging which is one of the keys to becoming a successful investor and earning potential higher returns. Dollar cost averaging will help reduce the amount of market risk your are exposed to so if you are not already using this technique, make sure to set up a plan aligned with your investment objective.

Dollar cost averaging example

If for example you would like to invest $10,000 in the stock market (in individual stocks, mutual funds or index funds), rather than investing the entire amount all at once, you could buy smaller amounts of shares over time which would protect you from market price fluctuations. For example, you could buy $1000 worth of shares each month for 10 months, or $2,500 dollars worth of stock each quarter.

As described in “The three key investing variables”, the savings rate plays a key role in the potential growth of your portfolio. Once you have identified a savings rate that you feel comfortable with, invest the capital by using dollar cost averaging.

Personally I buy a set dollar amount of shares each month. The savings rate is not exactly what I had hoped for (5%) but I’m trying to work my way up to the recommended 10-15% savings rate. I simply treat it as other fixed expenses, such as rent. Since I’m in for the long term, I ignore the actual market price but since I buy shares every month I’m able to reduce the overall market risk because when prices are lower I end up buying more shares, while when prices are high I end up buying less shares.

The long term effect of dollar cost averaging

The effects of dollar cost averaging will be even more visible when you follow a long term investment strategy. Combined with the annual rebalancing of your portfolio (to stay aligned with your asset allocation), it “forces” you to buy low and sell high.

Dollar cost averaging will also prevent you from putting too much capital in the stock market when it seems most exciting or not buying stocks after a market crash.

Check with your broker to see if it is possible to set up an automatic withdrawal process so that you are sure that capital is being added to your portfolio on a regular basis in order to fully take advantage of dollar cost averaging.

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