When you continuously contribute to your 401(k) account, you are benefiting from a dollar-cost averaging strategy, which can provide some protection to your retirement savings against short-term market fluctuations. In contrast to market-timing strategies, dollar cost-averaging helps you steadily accumulate investments without trying to predict market fluctuations. Dollar-cost averaging is basically just buying shares of an investment with the same amount of money on a periodic schedule, so that the number of shares may fluctuate from period to period, but the amount invested does not. This way, you may buy some shares at a higher price, and some at a lower price, over time. Dollar-cost averaging thereby averages out your overall cost and shields you from investing a lump sum during an inopportune time in the market.
Contributions to a 401(k) plan are a form of dollar-cost averaging: you’re using a predetermined portion of your paycheck each pay period to purchase the same allocation of fund shares, regardless of the market price.
For example, Peter Planner decides to buy $1,000 of Organic Orangutan Oculars (OOO) stock a month for four months beginning in January. OOO shares decline for the first three months, but then rebound in April.
After making consistent $1000 purchases over four consecutive months, Peter owns 201 shares in OOO. His average price per share is approximately $19.90 ($4,000/201 shares). OOO’s share price is $22 at the end of April, which is higher than Peter’s average price per share of $19.90. So, despite the share price dropping from $25 in January, Peter still makes a profit of $422 at the end of April!
Dollar-cost averaging works best with investments that do not charge a transaction fee, meaning there is no fee for buying or selling an investment. By utilizing dollar-cost averaging, you’re able to put your investments on autopilot and watch your savings grow over time.