How to use dollar cost averaging to build wealth

The best investors are those who have complete control over their emotions while making logical investment choices. However, that is easier said than done, which is why many investors employ dollar-cost averaging to assist them in controlling risk and take emotions out of the equation when making investment choices. 

Dollar-cost averaging assists investors in progressively increasing their holdings of a certain investment over a long time, barring unfavorable events.

A flawless investing plan does not exist. Dollar-cost averaging is a cautious approach that contributes to long-term wealth accumulation, particularly for those who are just beginning their investing career. To benefit from it, make sure you follow the strategy.

If you’d like to learn more about dollar-cost averaging including how to use it to build wealth over time, then keep reading. 

What is dollar cost averaging?

Investing a certain sum of money in a specific investment regularly, usually monthly or quarterly, is known as dollar-cost averaging. Due to its ability to reduce timing risk, this technique is most often used for riskier assets like stocks and mutual funds (as opposed to bonds or real estate).

Assuming, for example, an investor invests N500,000 every month in a stock for one year, their investment amount remains constant even if the ETF’s price fluctuates monthly. Theoretically, the investor will have been successful in using dollar cost averaging to achieve a positive return on his investment as long as the price of the ETF rises throughout that time frame.

Let’s say he starts on January 1st, and the share price of Mutual Fund XYZ was N50,000 in January, N40,000 on February 1st, N20,000 on March 1st, N50,000 on April 1st, and N60,000 on May 1st.

On the first of every month, the investor consistently contributes N500,000 to the fund, however, the quantity of shares that sum of money may purchase changes. 10 shares were purchased in January, 12.5 were purchased in February, 25 shares in March, 10 shares in April, and 8.3 shares in May. 

The investor has 65.83 shares of the mutual fund only five months after they started making contributions. The N2,500,000 investment is now worth almost N4,000,000.

The overall profit may have been larger or lower if the investor had spent the whole N2,500,000 all at once at any point throughout this time. However, the investment’s risk has been significantly decreased by spreading out the acquisitions.

Benefits of using dollar cost averaging

1. Avoid timing the market: By spreading out your investments over time, you can avoid the risky practice of “timing the market,” which involves putting all of your money in at once. If you end up investing when a stock reaches its peak, you run the risk of suffering a significant loss if the stock declines from there. By purchasing over time and averaging your purchase costs, you may lessen your risk.
2. Reduce risk: You may profit from a turbulent market by using dollar-cost averaging. Adding money regularly will allow you to buy when the market is down, which will decrease your average purchase price and allow you to acquire more shares. Your monthly payment will purchase fewer shares when the market rises, but because you already have shares from previous purchases, you will still benefit and not lose out entirely.
3. Benefit from bear markets: While stocks drop, people feel scared and stop purchasing them while they are inexpensive to prevent more short-term losses. You may prevent this psychological bias and profit from declining stock prices when everyone else is afraid by establishing a regular purchasing strategy when the markets (and you) are calm.
4. Reduces emotional investing: In terms of emotions, dollar cost averaging simplifies matters. You make the same monthly investment regardless of changes in the market. You will be less emotionally impacted by market volatility and less likely to make rash financial choices as long as you have the self-control to follow through on it.

How to use dollar cost averaging?

You may set up dollar-cost averaging for your investments by following these steps:

1. Decide which investment to make

You should first decide what you are purchasing. Would you want to purchase stock? Or will you choose a mutual fund or exchange-traded fund (ETF)?

Stocks are more likely to vary greatly than funds if you want to purchase them. However, finding a firm that lets you purchase stocks automatically could be challenging.

A fund should vary less than an individual stock if you purchase one. Additionally, since funds are more diversified, you won’t be as negatively impacted if any one of the fund’s stocks has a significant fall.

2. Find out how much you can afford to invest

Once you have decided on an investment to make, it’s time to determine how much you can consistently invest. You should be able to keep your money in the investment for at least three to five years when investing in any kind of stock or fund.

Determine how much you can invest, beginning with your monthly budget. The most crucial thing is to start investing consistently, even if it’s not much at first.

3. Decide on a frequency

How often you will invest will depend on your preferences. You can decide to invest weekly, monthly, or every few months. 

4. Set up your automated plan

Depending on the amount you want to invest regularly, and the frequency of transaction execution, you may configure an automated trading plan at your broker. Although each broker has a different procedure for setting things up, these are the fundamentals you’ll need regardless. Your broker can assist you if you have any further inquiries.

Additionally, if your fund or stock pays dividends, now could be a good time to have your broker set up automatic dividend reinvestment. The whole value of the dividend will be put to use rather than sitting in cash for a long period earning next to nothing. Any cash dividend will be utilized to acquire new shares, and you may often even buy fractional shares. Therefore, your dividend will continue to receive dividends even after the next payout.

5. Have a long-term mindset

The dollar-cost averaging approach is a long-term plan regardless of the amount you have to invest.

Even though the financial markets are always changing, most equities have a tendency to follow the same basic trend over extended periods of time as they are carried by the broader economic currents.

Both bull and bear markets may last for months or even years. As a short-term approach, it lessens the usefulness of dollar-cost averaging.

Furthermore, the value of mutual funds and even individual equities often does not fluctuate much from month to month. To appreciate the advantages of dollar-cost averaging, you must continue to invest during both good and bad times. Both the higher prices of a bull market and the lower prices of a bear market will eventually be reflected in your assets.

Things to consider before making an investment

Dollar-cost averaging is one of the best investment strategies out there, but it will not work for everyone. There are several things you need to consider before using this technique:

1. You need to be disciplined enough to follow it: Despite the saying “buy low, sell high,” many investors wind up doing the exact opposite of not making their normal investment while the market is down since they may feel quite inclined to sell. That would, however, negate the fundamental tenet of the approach, which is to increase investment purchases when the market declines. Additionally, by using this technique, you are unable to adjust your position in response to changes in the share price of your investment. For example, you cannot increase your expenditures to buy more shares when the price is lower and decrease them when it is higher.
2. You still need to choose the appropriate investment: The process of selecting a suitable asset to invest in is not made easier by dollar cost averaging. A poor investment that has a dollar cost average is still a bad investment.
3. Be mindful of transaction costs: Frequent and consistent investments result in more transactions, which might reduce your profits. As a result, a lot of investors who use dollar cost averaging would rather continue investing in inexpensive, passively managed index funds that have a small percentage-based fee.
4. You could have fewer shares than you first anticipated: You can receive fewer new shares with each investment if the share price of the investment increases over time.

Conclusion

Over time, dollar-cost averaging has shown to be a profitable investment strategy for many individuals, however, it may vary depending on your unique circumstances. The issue is whether you should use the dollar-cost averaging strategy to make regular purchases over time or schedule your purchases according to market circumstances. Timing the market has shown to be quite difficult and most individuals are better off with a regular investing strategy.

Taking advantage of a turbulent stock market, dollar-cost averaging is an easy method to help lower risk and boost profits. You may spend your time doing the things you like instead of investing if you set up your brokerage account to purchase stocks or funds automatically and regularly.