Most people don’t have $10,000 to plop down on a stock or mutual fund investment at once. Putting a little bit of money down consistently to invest over the long term may be the best option. (It may be the only option.) Many people don’t know the power of dollar cost averaging. The concept is simple but, because it is simple most people overlook it.
The general move of the stock market is up over the long term. If you buy now and keep the stock for a long time you should have a profit if the underlying company is profitable. This strategy is called buy and hold.
Of course the value of a stock usually goes up and down in the short term. The idea of dollar cost averaging is to buy a stock periodically over a long period of time based upon a set dollar to be spent rather then the number of stocks. It is an extension of the buy and hold, the difference is you are buying, holding and waiting a set period of time to buy again, repeat the buy, hold and wait, and repeat as long as you desire.
I have purchased stocks this way and set my period for once a month. I was able to spread the risk by buying stocks periodically. If the stock goes down in value you would purchase more stock and if the stock goes up in value you would purchase less stocks with the same dollar outlay. When the value of a share increases the shares you already own are more valuable. I wrote about purchasing individual stocks in one of my previous posts.
The bad thing is with individual stocks there are risks. If you buy individual stocks of one company you are betting on one horse in a horse race with thousands of horses. Why not bet on multiple horses and use the general upward movement of the stock market while reducing your risks.
Buying a mutual fund eliminates some of that risk by dividing your cash among multiple companies. The index funds seem to be the best choice due to the low fees for the long haul.
There are other risks involved like:
1. Currency depreciation – the currency trading in goes down in value
2. Stock depreciation – the company owned goes down in value
3. Company collapse – the company whose stock you own go bankrupt
4. Premature cash out – You need to sell your stock before you wanted to due to needing the money
Some ways dollar cost averaging index mutual funds reduces these risks are:
1. You are continuously buying over the long haul and depreciation of currency usually happens over time. The value of the stock is valued in today’s dollars and will self correct to a point. (be wary of companies who don’t keep up with inflation.)
2. By purchasing index mutual funds if one company goes down in value others should not go down in the same rate. (Although the market will take a dip at times. *** This is the time not to dump and run; that’s how people lose money. Instead buy more. – buy low; sell high)
3. Company collapse are inevitable; however if you own an index mutual fund those companies that are about to collapse usually are no longer in the index by the time they implode.
4. Premature cash out is the biggest risk individuals face as an investor. One way to reduce this risk is to not be in debt and have an emergency fund so you won’t have to dip into your investments if a financial need occurs. Emotion can have a big roll in the premature cash out. Have a entry and exit plan when you buy an investment you are less likely to buy or sell based upon emotion.
Dollar cost averaging purchasing of index mutual funds gives me piece of mind knowing I’ve reduced some risks involved with stock investments as well as a better chance at gains with low fees and consistent increase of value over the long haul.