I’m not an expert on the stock market. I don’t have the time to research companies and check the financial news every day. You’re probably the same.
That’s why I like to invest in index funds. An index fund is one that spreads your money across several hundred top companies on the stock market.
When you invest in an index fund, you will match the overall return of the market. One or two of those companies may go bust, but most of them will do well over time.
Spreading your money across different companies minimizes your risk, and so does spreading your money across different points in time, to avoid investing too much at the wrong time.
This technique is called dollar cost averaging. I explain it further in this video.
WHY DOLLAR COST AVERAGING?
Dollar cost averaging is when you invest the same amount of money at fixed intervals. This might be $200 per week into an index fund.
The rationale of dollar cost averaging is that no one can predict the future.
Critics of dollar cost averaging will tell you that if you invest big when the market is about to experience a major upswing, and sell just before it’s about to fall again, you’ll maximize your returns.
That may be true, but how do you know when that major upswing will happen?
Dollar cost averaging doesn’t promise to maximize your return. It only promises that you’ll get an average return.
I don’t know about you, but I’d rather have a guaranteed average return than risk investing all my money at the wrong time.
AN EXAMPLE OF DOLLAR COST AVERAGING
Let’s look at an example of dollar cost averaging and how it can benefit you.
You decide to invest $200 every week into an index fund. On the first week, the market price is $10, so you buy 20 units.
By the second week, the market price has gone down to $8. The rule of dollar cost averaging is that you still invest the same amount. So this time, you invest the same $200, but it now buys you 25 units.
Without the discipline of dollar cost averaging, most investors would let their emotions take control. When the market price goes down, they will become shy and decide to buy less.
Even worse, they try to time their investment. When the market has been doing well, they decide they’re feeling lucky and they invest a big lump sum. Immediately after, the market suddenly takes a dive!
Dollar cost averaging takes the emotion out of investing and ensures you won’t make mistakes like these.
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