Dollar-cost averaging is making periodic purchases of an investment so that you are spreading out the risk of suffering from poor returns as a result of buying too high (i.e. poor timing) when you start your investment. In other words, rather than invest $20,000 tomorrow (when the U.S. stock market is near an all-time high and the U.S. bond market rates are near an all time low), you might make $4,000 investments each month for five months, or $2,000 investments each month for 10 months. When the price of what you are buying is lower, then dollar-cost averaging will result in buying more shares, and vice-versa when the price is higher, thus you are “averaging” into the investment, without engaging in market timing.

Most of us already engage in dollar-cost averaging through our 401(k) plans, as money is taken out of our paycheck each pay period throughout the year and put into our investments. You can do the same thing with your IRAs, HSAs and taxable accounts too, by spreading out when you invest the money in those accounts throughout the year. For example, we tend to make our IRA contributions and investments early in the calendar year but our HSA contributions and investments later in the year once we feel certain that we are stuck with our high-deductible plan for the whole year and could therefore deduct our HSA contribution.

In addition to decreasing your risk of unlucky market timing in making an investment, dollar-cost averaging has some psychological benefits. Specifically, if the market is going down, while we have no idea whether it will last or not (i.e. the post-Brexit drop and recovery) dollar-cost averaging will take advantage of the market bottom and provide a hedge against your natural desire to sell everything when the market is doing poorly.  In fact, dollar-cost averaging essentially guarantees that you will sometimes buy low!

The biggest problem with dollar-cost averaging is that most ETFs and stocks charge a fee on every purchase. If you are dollar-cost averaging every month in multiple accounts, then you may be paying too much in fees, which can destroy your wealth. This can be mitigated by using ETFs or mutual funds that your brokerage has agreed to let you buy without a fee. For stocks, in which the trading fee cannot usually be avoided, you want to make sure your purchases are of a high enough amount that the fee is not a factor. So do not buy stocks if you are dollar-cost averaging in increments of $100, since the fee will be 7-10% of your investment, but if you are investing in increments of $1,000, then that trading fee will be less than 1% of your investment, which is more acceptable (though still not ideal).

-Richard

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