Given the market’s recent volatility, it is natural for most investors to wonder when to invest in the markets. The answer is anytime, provided you do it on a systematic basis using a time-tested strategy — dollar-cost averaging. After all, it’s not about timing the market, it’s about time in the market. Dollar-cost averaging allows investors to build a portfolio and help protect against wild fluctuations while continuing to accumulate assets.
It involves making regular investments of consistent dollar amounts over an extended period of time. This can happen on a bi-weekly, monthly or quarterly basis. For example, if you have $6,000 in cash, you could invest $1,000 per month in a mutual fund. That way, you avoid putting all of the money to work today if you are concerned about whether the market may be in for a temporary downturn. At the same time, you are still able to actively invest your money in the market with the aim of achieving long-term goals.
A strategy that can work in many markets
While dollar-cost averaging does not assure a profit or protect against a loss in declining markets, it is a strategy that can help cushion the impact of market volatility in your portfolio and often work to your advantage even in circumstances when markets are in retreat.
Consider an example of an investor who puts $1,000 per month to work in a mutual fund. Timing appears bad because in subsequent months, this fund goes down in value significantly before making up only some of the lost ground at the end.
For example, if an investor pays $20 per share in the first month, resulting in a purchase of 50 shares for a $1,000 investment, the price could vary anywhere from $5 to $15 in later months. Shares would potentially be purchased at each of those prices. While the investment lost value, the investor benefited by buying more shares with each $1,000 invested every month.
At the end of six months, the total investment of $6,000 would have grown to a value of $7,167, or a 19.5 percent gain for the period. This is despite the fact that the fund itself lost 50 percent of its value during that time.
Consistency is key
The reason dollar-cost averaging can work so effectively in a situation like this is because the investor maintains a consistent investment strategy regardless of market conditions. If the price goes up in one month, then fewer shares are purchased. If the price goes down in a month, more shares are purchased. In the example outlined above, the investor benefited because the average price paid for each share was relatively low throughout the period, just $8.37 per share. Remember that this is an investment that started at a value of $20 per share. By the end of the six-month period, with the share price rising to $10, the fund’s value was already higher than the average share price paid by the investor of $8.37 per share.
By maintaining a disciplined approach through a challenging market, the investor not only realized positive returns, but was now well positioned if the fund should recover its full value and continue to generate favorable returns going forward.
A possible solution for volatile times
When markets are fluctuating wildly, dollar-cost averaging is a method that can put that volatility to work for you. It is critical to make a commitment to continuous investments regardless of how much prices may fluctuate. Investors also need to determine whether you are in a position to make ongoing share purchases even through periods of market declines.
If you already make regular deferrals from your paycheck into an employer-sponsored retirement plan you already use the strategy of dollar-cost averaging. While many have seen the value of their retirement accounts decline due to recent setbacks in the market, the benefits of dollar-cost averaging make a strong case for investors to remain confident about their long-term prospects. If you have continued to invest every month, you are likely building up larger share purchases due to today’s lower prices. While you may be disappointed in short-term results consistently using dollar-cost averaging you may see better returns over the long term if the markets go back up.
In the current volatile market environment, support from your financial advisor can be critical to creating a plan to suit your individual risk tolerance and financial situation.
This information is provided for informational purposes only and is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or your financial advisor.
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