There are many strategies that investors can use to build their portfolios, and wealth over time. Though many require complex procedures, extensive knowledge of financial instruments, and quantitative analysis, perhaps none comes simpler than dollar-cost averaging. This article shows how you can build wealth by using this simple technique.
What Is Dollar-Cost Averaging?
Dollar-cost averaging is a simple investment strategy that entails making periodic installments from a stipulated total in acquiring an asset or financial instrument. Here, the investor divides the total amount which he intends to invest in an asset into smaller amounts and invests them periodically over a period of time. This investment may be done monthly, weekly, quarterly, or when the price of the asset drops by a certain percentage. By making these periodic investments rather than investing the amount whole, the investors can pay a lower average price paid for the asset.
For example, an investor wants to invest $1000 in Apple shares. Rather than invest the whole amount at once, he can decide to split the amount into five smaller amounts, which would be used to purchase Apple shares over a period of time or if the price of Apple shares drops by a certain percentage. This allows him to acquire Apple shares at a lower average price than if he had invested the amount whole.
When done properly, DCA can be used to compound wealth over a period of time. The effects of the strategy are similar to compound interest, though in the case of the latter the outcome is somewhat more predictable and fixed. Perhaps a more suitable example of DCA is your 401k plan where a stipulated amount is deducted each month towards the purchase of equities, mutual funds, or index funds.
How DCA allows you to build wealth
Dollar-cost averaging allows you to build wealth because the returns from your investment are compounded over time. As you purchase shares, the number of holdings in a particular stock increases. This is further increased by dividend payments and share price appreciation. As you continue to contribute, your nest continues to grow and your capital appreciates.
Secondly, during periods or corrections or in bear markets, you can get more shares at a lower price which reduces your overall costs and increases your margins when the share price increases.
Thirdly, it enables you to pay less attention to market movements and more attention to accumulating your holdings. Since DCA is a long-term investment strategy that requires the investors to hold for a long time, you are less susceptible to selling quickly which ultimately reduces the propensity of selling at a loss or too soon thereby leaving money on the table.
Fourthly, DCA also helps to build character and strong fiscal discipline needed to be financially independent and wealthy. By making regular investments, it allows the investor to discount the pleasures of today for future benefits thereby securing a more financially rewarding future. Even in periods when income rises, you can still maintain the same standard of living without the pressure of wanting to keep up with the Joneses.
When is DCA ineffective?
There are situations where DCA would be ineffective in enabling you to build wealth. Making periodic withdrawals from your investment ultimately reduces the amount you are able to accumulate over time and by extension reduces your momentum towards building wealth and achieving financial independence. Thus, if you want to succeed with this strategy, maintaining a long-term mindset is very crucial. Even in periods when your income may have increased, you should increase your monthly investment allocations before you increase your monthly expenses.
Also, if the price of the asset continues to appreciate, this means that you may be spending more than if you had invested the amount whole. Even if you decide to wait for a correction or drop in price, you may be waiting for a long time or run out of patience. In situations like this, it is worthwhile to remind yourself why you are investing and the long-term benefits of setting money aside for your future.
Thirdly, DCA may be less potent when you are close to your retirement. Though there is never a bad time to save and invest, using the DCA strategy when you have 10 years or less to retirement may not allow you to reap the benefits of this strategy. One way to get around this is investing larger amounts as you edge closer to retirement so that the compounding effects of DCA can be better reflected in your portfolio.
The bottom line
Dollar-cost averaging is a simple and effective strategy that can be used by investors regardless of knowledge, capital, or experience. It reduces the risk that comes with frequent trading, trying to time the market, or responding to knee-jerk reactions. It also helps investors build traits such as control of emotions, and patience, long-term view, which would enable them to be better money managers. Make sure that you are wholly committed for the long-term before committing to DCA investing.
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