What you need to know about the dollar cost averaging investment strategy

If you’re already contributing money to a 401(k) retirement account, you may not have realized it, but you’re practicing a popular investing strategy known as cost averaging.

In simple terms, this approach means that you invest fixed, equal amounts on a regular basis, say monthly or every two weeks, rather than investing a single amount of money all at once.

With a 401(k) defined contribution plan, for example, you invest as you earn, regularly taking money from each paycheck throughout the year and putting it into the market. The cost average could also look like if you decided to invest $5,000 of your savings by dividing that money into five parts, where $1,000 is invested each month for five months.

Averaging allows you to spread out your investments and buy in the market at different times at varying prices. In turn, these purchase prices ideally balance out, hence the “average” part of the phrase.

Experts often recommend this long-term investment approach (particularly with broad market tracking index funds) to people with a low appetite for risk, as providing liquidity consistently over time reduces risk. impact of any market volatility on an investment. Not to mention that this allows investors to forget about the up and down movements of the market since their contributions are not influenced by what is happening; they pay dues at regular intervals no matter what. It helps to leave out emotion-based investments.

Cost averaging is often compared to its antithesis, lump sum investing, an opposite approach otherwise known as simply timing the market.

Like dollar cost averaging, lump sum investing can also help you build wealth and, even better, maximize your returns, but with the caveat that you take on a lot more risk. After all, as we all know, no one can really time the market.

When you invest a large amount of money in the market all at once, your money is immediately put to use. With cost averaging, however, only part of your money goes into the market to begin with and the rest is set aside for future contributions – this might allow you to catch up to future market declines, but your immediate gains may be lower if the market takes off earlier than expected.

When investing with a method or strategy, the first step is to identify the potential returns as well as your risk tolerance.

While you can get better returns over time with a lump sum investment, it’s not a good idea for those looking to reduce their short-term downside risk, as the potential for loss is greater.

Risk-averse investors, or those who are concerned about market volatility, are better off using the dollar cost averaging approach to investing. A good place to start is an S&P 500 index fund that has posted an average annualized return of around 10% since 1957.

For example, Charles Schwab’s S&P 500 index fund is a simple option with no minimum investment. Its expense ratio is 0.02%, which means that every $10,000 invested costs $2 per year. Index funds typically have an expense ratio of 0.2%, which is particularly low.

For an option with no spend ratio, consider the Fidelity ZERO^® Large cap index fund. While the fund doesn’t technically track the S&P 500, the Fidelity US Large Cap Index tracks large-cap stocks, which the website says “are considered the stocks of the 500 largest US companies.”

You can also consider investing a fixed monthly amount through a robo-advisor like Betterment, which will create a personalized portfolio of ETFs (which are similar to index funds) for you based on your risk tolerance and of your investment horizon.