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During this unprecedented time of crisis, the volatile stock market is on everyone’s mind. While it is hard to feel good about any market decline, using a long-term dollar cost averaging strategy could provide bright side to this down market.
The concept of dollar cost averaging is simple. You just invest a fixed dollar amount every month, quarter or other regular interval. This type of systematic investing is a built-in benefit to 403(b), 457(b), 401(k) and other workplace retirement plans where contributions are taken automatically from each paycheck. You can also integrate a dollar cost averaging strategy into your IRA and other savings plans by making equal contributions that are automatically deducted from your bank, as long as your total contributions do not exceed the annual IRA contribution limits.
The benefits of dollar cost averaging are best realized with longer-term investments in fluctuating markets. When the stock market is down and prices are lower, your fixed contribution amount buys more shares. When the market is up, your systematic contributions purchase fewer shares at higher prices. In markets that fluctuate in the short term but rise in the long term, the results can be more shares purchased, a lower average price per share and a higher ending value.
To see how this works, take a look at the above table that compares an investment that fluctuates in price to an investment with a steadily increasing price. Notice that when share prices are lower, each $100 contribution buys more shares. Also, notice that when share prices fluctuate up and down, the end result is more shares purchased and a higher ending value.
By making a fixed investment on a regular basis, you can take advantage of down markets and purchase the same investment at a lower price, which may translate into higher returns when the market recovers. Dollar cost averaging also encourages discipline and helps take the emotion and guesswork out of investing. However, dollar cost averaging does not ensure a profit nor protect against loss in declining markets. And because dollar cost averaging involves continuous investment in securities regardless of fluctuating price levels, you should consider your financial ability to continue your purchases throughout periods of market fluctuations.