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How to Use Dollar Cost Averaging
Investing in mutual funds is less risky than investing in individual stocks because diversification spreads the risk over a large number of stocks which are evaluated and selected by professionals. Regular, periodic investing in mutual funds is a standard way to save for retirement and other long range goals. Investors should not panic if the stock market goes down because "Dollar Cost Averaging" actually helps them when their mutual funds are cheaper. Here's how this works.
Don't Sell Mutual Funds Just Because the Market Goes Down
It is usually a mistake to sell your mutual funds just because the market has gone down. That would merely lock in the loss. It is normally far better to continue regular investments of the same dollar amount during market downturns, and perhaps even increase the amount invested at each interval.
Invest for the Long Term
As an example, let's say you have been investing for several years in a mutual fund either in a 401k or IRA for retirement with regular deposits of $500 a month, and you now have 1,000 shares at an average cost of $40 a share. So you have invested $40,000, but the market goes down and say your mutual fund share price is now $25 each which means your 1,000 shares are worth only $25,000. Don't sell and lock in a $15,000 loss! Your investment is for the long term and you should be able to ride out market dips.
Take Advantage of Market Fluctuations
Continuing the example above, suppose the share price stays at $25 for two years. Then you will have invested $12,000 ($500 a month x 24 months) and purchased another 480 shares. At the end of this period, if the price goes back up to $40 per share, you have 1480 total shares at $40 each, worth $59,200 (1480 x $40). Your total investment was $52,000 ($40,000 + $12,000), so you have made money ($7,200) by buying more shares when the price was low.
Make Dollar Cost Averaging Work for You
Make up your own examples and you will see that regular deposits of a given amount of money work in your favor when the market fluctuates. This is because that same fixed investment amount buys more shares when the price goes down than when the price goes up. This is known as dollar cost averaging (DCA). Dollar cost averaging makes you money as long as the fund returns to its long term average share price. Which for successful mutual funds, they always have or have risen even higher.
Choose the Dollar Cost Averaging Strategy You're Comfortable With
There are two main DCA strategy choices in down markets. The first is to maintain your regular investment amount which will buy a greater number of shares and takes advantage of dollar cost averaging. The second, more aggressive strategy, is to increase your regular periodic investment amount in a down market to leverage dollar cost averaging even more. If you have faith in the long term economic outlook, the more aggressive strategy would make you more money.
Cautions and Other Considerations
Only invest in mutual funds that have proven track records of at least five years. Get professional advice if you think you need it in choosing among mutual funds. Also, it is better to invest in multiple mutual funds than to invest all your money in just one fund.
Dollar cost averaging isn't necessarily the best strategy if you have a large fixed sum to invest. Seek professional financial advice in that situation.