As we navigate this period of market turmoil, there is a great deal of advice around how to manage (or leave alone) your retirement plan. It’s particularly common to hear finance analysts and pundits talk about the benefits of dollar cost averaging (DCA) since it’s a popular way to manage investment risk during periods where the market may be declining or volatile.
According to Investopedia, “dollar cost averaging is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase.” So rather than investing a lump sum, you can invest that amount over a period of time, such as 25% in each of the next four months.
The idea is that diversification doesn’t just apply to investments; it applies to timing. Market timing is impossibly hard, so rather than investing all at once where you can lose a large amount if markets fall, you can invest that sum over a period of time. There’s been a wide body of research on the topic, showing that in periods of market volatility, dollar cost averaging can be very effective.
There are two ways you can use dollar cost averaging with your 401(k):
- If you’re putting away a percentage of your paycheck, congratulations! You’re already dollar cost averaging. Keep saving for retirement and follow your retirement strategy.
- If you’re thinking about reallocating your portfolio, you can shift your allocation towards stocks incrementally over a period of time rather than immediately.
Outside of your 401(k), if you have money to invest outside of your “emergency savings” and other investment goals, you can practice dollar cost averaging by investing it over a period of time rather than immediately. Let’s say you intend to move $4,000 to an account. Rather than moving it all at once, you can move $1,000 for each of the next four months. In effect, you’re reducing your risk in the event the market continues to fall.
If you’re trying to implement a dollar cost averaging strategy, be sure to ask an investment advisor. Or, if you’re a self-help learner, there are plenty of resources online.
Vestwell is not a law firm or tax advisor. Participants may wish to consider hiring their own professional before making any changes to their retirement plan, as there could be tax consequences and other adverse impacts on their retirement plan.