Your Ultimate Investing Guide to Dollar Cost Averaging and Building Wealth

dollar cost averaging

“I just don’t have enough money to invest.”

Does this sound familiar?

One of the most common investing myths is that you need a lot of money to invest. The good news is that you can start investing with a relatively small amount of money. And grow your portfolio consistently over time.

The key is to use dollar-cost averaging to your advantage.

What is dollar cost averaging?

The idea behind dollar-cost averaging is simple: every month, you invest a set dollar amount. Your investment buys as many shares as possible at the price offered.

Let’s say you decide you can invest $250 each month. You choose an ETF with a share price of $50 and during your first month, your investment buys five shares.

Yet, by the time you’re ready to buy the next month, the price has gone up to $75 a share. Now you are only able to buy three and one-third shares. However, your portfolio is still growing, and you have more shares than you did at first.

But what happens when the market drops? Your ETF’s share price has dropped all the way down to $25 a share. Now your $250 investment buys 10 shares of that ETF. You add that to your portfolio, and it continues growing.

Over time, your consistent investment means that you keep adding shares to your portfolio. The idea is to grow the number of shares you own over time.

Later, after your portfolio has had a couple of decades to grow and you decide to sell it, you realize that you have accumulated hundreds — or even thousands — of shares.

Essentially, your consistent investment has paid off because you have a large number of shares in your portfolio that you can sell at a price that is likely to have grown over time.

Get started with dollar cost averaging

One of the best ways to start dollar-cost averaging is to open a brokerage account and set up an automatic investment plan.

Most online discount brokers are willing to let you invest a relatively small amount of money (usually as little as $50 or $100) each month when you agree to an automatic investment plan.

When you start your plan, you will choose how much to invest, how often you will invest, and the assets you will buy.

Here are some things to consider as you set up your automatic investment account.

Start with index funds or ETFs

Index funds and ETFs can be ideal for dollar-cost averaging because they offer instant diversity by providing exposure to a wide swath of the market.

Instead of trying to pick the “right” stock, you ride along with long-term performance. This isn’t a bad thing because the market as a whole tends to go up over time.

If you look at the long-term performance of an index like the S&P 500 as of this month, you can see that there are drops. However, the overall trend line moves up.

sp-500-index

Index investments can help you sleep better at night and limit your risk over time.

Consider funds that pay dividends

Many index funds also pay dividends because the companies followed by the index pay dividends.

Look for a broker that will automatically reinvest your dividends for free. Reinvesting dividends boosts the number of shares you have, growing your portfolio and potentially resulting in better overall gains in the long run.

Search for fractional shares

Some brokers will let you purchase fractional shares if you have an automatic investment plan. This means that if your regular investment can buy half a share, you get that added to your portfolio.

Other brokers just let the excess money sit in your account, and you only buy another share when enough extra adds up to the share price.

If possible, try to get a plan that allows you to buy portions of shares, instead of insisting that you buy whole shares each time.

Check into your employer’s retirement plan

One of the best and easiest ways to start dollar-cost averaging is to use your employer’s retirement plan. Money that comes out of your paycheck represents money that you can dollar-cost average.

If you can get a match from your employer, so much the better. That’s free money that allows you to buy more shares — and grow your wealth faster.

Pick a day of the month that’s convenient

If you don’t have an employer-sponsored retirement plan, you’ll need to pick the day for an automatic withdrawal from your bank account.

Make sure you have money in your account on the day your money will be withdrawn. That’s very important.

Also, review your spending plan to determine when you’ll have money in the bank. Coordinate your other bills so you don’t overdraw your account.

Increase your contribution when you can

Don’t forget to increase how much you set aside.

While you can start with as little as $50 or $100 to dollar-cost average, that’s probably not enough for your to reach your financial goals. Boost what you add each time your financial situation improves.

What about lump sum investing?

If you end up with a large, unexpected chunk of capital, what should you do? Does it make sense to dollar-cost average it? Or should you invest the whole amount?

For most people, you’re actually better off investing the entire amount. The site Moneychimp offers a great calculator that can help you determine likely scenarios.

In most cases, you’re better off putting the entire lump sum into the market, rather than dollar-cost averaging.

Lump sum investing makes sense for a large sum of money that you have in hand. However, it’s important to begin investing with whatever you have on hand as soon as possible.

Saving up until you have a lump sum isn’t very effective. Instead, you’re better off earning as much compound interest as possible — and growing your portfolio.

Investing 101

At the end of the day, dollar-cost averaging is one of the easiest ways for you to start investing. Especially when you are worried that you don’t have enough money.

Dollar-cost averaging allows you to break your investments down into smaller, manageable chunks. Ultimately, the earlier you start, the better off you’ll be when it comes to building long-term wealth.

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