Everyone loves a big income tax return, but it is better to get the money throughout the year, rather than a big lump sum at the end of the year.
What is Dollar Cost Averaging?
Dollar cost averaging is an investment strategy that is meant to provide the largest rate of return over time. An investor puts in a fixed amount of money every month into their portfolio regardless of the economic climate. The theory is that when the market is down, investors can buy more shares automatically, and when the market goes up those shares prices will grow exponentially.
Dollar Cost Averaging Scenario
Savvy Sara invests $100 per month in stock X. The stock initially cost $50 a share. For the first month she is able to buy 2 shares. The following month, the market takes a dip and the stock price goes down to $10. That month she is able to buy 10 shares. The stock goes down again the next month to $5 and she is able to buy 50 shares. She now owns 62 shares of stock X.
The economic climate gets better and stock X goes up to $10 a share. She is able to buy 10 shares. The market is doing fantastic and the stock goes up to $100. She can only buy 1 share this time, but she now owns 73 shares of a stock that is worth $100 per share. On paper, she went from owning 2 shares for a total of $100 to 73 shares valued at $7300.
Savvy Sara did fantastic in riding our the economic dip. Had she been too emotionally attached to the numbers, her investment strategy would have failed since she would have probably sold everything when stock X hit $5. She would have cashed out her stocks at $250 after buying the 50 shares at $5 which would have been a potential loss of $7250. Dollar cost averaging makes buying low and selling high automatic, so long as the person actually sells high, and holds on when the market is low.
Federal Income Tax Withholding can help with Investment strategy
By increasing federal income tax withholding, there is more money in the bank per month to dollar cost average. Instead of throwing everything into a portfolio at once when tax return season comes around, there is a gradual investment. A person's tax return will be lower, but the gains of that money will be greater because it is put to better use by investing.
Remember that increasing monthly income for investments will only work if the investor is responsible enough to really use that money for investing. It is tempting to go out and spend that money that only appeared to never be there before. The goal is to not blow the money monthly, like many people blow it at the beginning of the year when they get their tax returns.
This article is intended to provide basic investing information.For more information talk to a financial planner and go to Internal Revenue Service to see the legal withholding amounts a person can claim.
Carmen Sofia Grant - Carmen is a social media marketer, freelance writer, and blogger. Her favorite blogs are MomCrunch and Social Media Examiner.com
