Investors who are nervous about the stock market’s ups and downs can use a simple 401(k) investing approach to soothe their anxieties and be more disciplined with their money — and reap the possible financial advantages.
The technique is known as “dollar-cost averaging.”
It comprises investing money in equal tranches and at regular periods, independent of market conditions. Those who join employment retirement plans, such as a 401(k), may do so without ever realizing it because a portion of each paycheck is automatically invested.
The Financial Industry Regulatory Authority provides an illustration of how it works: Assume you have $10,000 in savings or a $10,000 bonus. Dollar-cost averaging would require you to invest that money over time, for investing $1,000 every month for ten months, rather than all at once as a $10,000 lump amount.
Consistent donations make investing more appealing.’
Among the key advantages of dollar-cost averaging are: It removes the emotional component of investment.
“Doing a little bit over time will average out the good days and bad days [in the market] and make it a more palatable experience for you,” said Sean Deviney, a Fort Lauderdale, Florida-based certified financial adviser.
For investors, emotion may be a dangerous factor. For example, fear of losing money can lead to risky behavior such as attempting to time the market, which is equivalent to estimating the ideal moment to purchase and sell.
Unfortunately, these initiatives “often backfire,” according to Finra.
People frequently sell out of panic when equities fall in value, missing out on possible gains when markets rise, according to the regulator. For example, the S&P 500 stock index fell over 20% last year, its worst performance since 2008. Investors that sold out have missed out on a nearly 12% return in 2023.
People may rush in while equities are rising — and purchase just when stocks are set to fall.
There are several reasons to be concerned these days, including the ongoing conflict in Ukraine and the possibility of a recession.
“There’s always going to be a reason not to invest,” Deviney, director at Provenance Wealth Advisors, said. “If you are constantly looking for reasons not to invest, you are missing out on long-term wealth accumulation.” Dollar-cost averaging helps a little bit with it.”
The method can also aid in the reduction of regret. According to Charles Schwab, investing smaller sums of money in pieces makes it easier to swallow a badly placed investment.
When a one-time investment makes sense
However, dollar-cost averaging isn’t always the greatest strategy, nor is it appropriate for everyone.
According to Finra, investors who can resist the desire to sell during bad times may benefit from better long-term profits by investing in a single amount rather than breaking it up. This implies the investor holds the money in cash, which has lower long-term returns than equities.
According to Finra, dollar-cost averaging may result in higher costs for investors if they suffer a cost for each transaction.