One of the biggest deterrents for new investors is the idea that you need a lot of money to get started. When you're still learning the ropes, the thoughts of putting a significant amount of money at the mercy of the market is very scary.
However, there is a strategy that allows you to get skin in the game while you're still learning: dollar-cost averaging.
Dollar-cost averaging means that you invest a fixed amount of money into the same fund or selection of stocks at regular intervals over a period of time.
For example, a great way to start dollar-cost averaging would be to invest $100 into an ETF that tracks the S&P 500 -- like the Vanguard S&P 500 ETF (NYSEARCA: VOO) -- on the first day of every month.
The key to dollar-cost averaging is consistency. In order for the strategy to work effectively, you need to make sure you're fastidious in your investing and add more money to your portfolio every month.
There are three primary types of dollar-cost averaging: Basic DCA, Value DCA, and Momentum DCA.
Basic dollar-cost averaging is, well... basic! It is the simplest type of dollar-cost averaging and means that you invest the same set amount of money (a fixed dollar amount) into your portfolio every week/month -- regardless of other happenings in the market. Once you have decided on the amount you wish to invest and the frequency, all you have to do is decide what stocks the money will go into.
One important thing to understand with basic dollar-cost averaging is the relationship that forms between the number of shares you buy and the movements of the market. If the share price of the investment drops in one particular month, you will end up buying more shares because the amount you are investing is still the same. Similarly, if a share price increases, you will get fewer shares per fixed dollar amount.
With Value dollar-cost averaging, you still make regular investments on a predetermined schedule. However, the difference between Value DCA and Basic DCA is that the amount you invest changes depending on the performance of your stocks.
If the price of the stock(s) you're investing in falls over the last month, you increase the amount of money you invest in it next time. If it rises, you decrease the amount. This means that you are increasing the number of discount shares you are getting by buying low and decreasing the number of expensive shares you are receiving by not buying when it's high.
Momentum dollar-cost averaging is similar to Value dollar-cost averaging but flipped around. So in this case, you decrease the investment after a negative month and increase the investment after a positive month. This allows you to ride on the wave of upward trending stocks and focus less on underperforming ones.
One of the biggest advantages of dollar-cost averaging is that it removes emotion from the equation. Humans are constantly trying to look for patterns in the chaos and can often become paralyzed by decisions. Nowhere is this more evident than the stock market.
Take the recent COVID-19 induced volatility, for example. Many investors became obsessed with the day-to-day swings of the market, trying to sell high and buy low. While this makes sense in theory, it is an incredibly difficult strategy to execute in practice and often ends up with you losing more money than if you'd just done nothing at all.
Dollar-cost averaging is often considered a hedge against market volatility. By consistently investing, you can take advantage of the average historical return of 10% that the market has experienced since its inception in 1928.
Let's use this as an example. If we are to assume that the market returns an average of 10% per annum, a $100 investment per month over five years would equate to just over $7,300 -- $1,300 of which would be interest accrued on the principal invested.
When we push this dollar-cost averaging strategy out to ten years, it becomes a much-more impressive $19,125.
And what about twenty years? Well, if you managed to dollar-cost average for that long, you could be sitting on $68,730 at the end -- almost $45,000 of which is interest accrued on the investment.
Not bad for a $100 investment per month, is it?
There are two primary drawbacks to dollar-cost averaging.
The first is the charges you might incur from your broker by investing on a regular basis. However, with the rise of low-cost digital brokers, this isn't as much of a concern for investors as it was in years previous.
The second drawback is missing out on more explosive returns you may experience by investing a lump sum of money all at once. Again, it is important to remember that this is entirely dependent on being able to time the market and is a much more time-intensive way to invest. For the average investor who plans to put a bit of money aside each month to work for them, dollar-cost averaging is undoubtedly the best (and easiest) strategy.
If you want to start dollar-cost averaging, the first thing you should do is identify the stocks that you want to invest in.
For a new investor, it's wise to start off by building a solid base of large-cap companies and ETFs that are less prone to market volatility. These could include companies like Amazon (NASDAQ: AMZN), Apple (NASDAQ: AAPL), Facebook (NASDAQ: FB), or Google (NASDAQ: GOOG).
Next, you should identify some mid and small-cap companies to add to your portfolio. These are companies that are more likely to experience more explosive growth than the large-cap companies and include the likes of The Trade Desk (NASDAQ: TTD), Roku (NASDAQ: ROKU), and StoneCo (NASDAQ: STNE).
Diversifying your portfolio is crucially important as it reduces the level of risk you're exposed to.
Then, once you have identified the stocks you want to build out your diversified portfolio with, you should set up an automatic bank transfer of money from your bank account every month into your brokerage account. You could set this up on the day you typically get paid, for example, to ensure that you always have money on hand to invest.
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