Dollar-cost averaging is the practice of investing a consistent dollar amount in the same investment at regular intervals. Investors looking to reduce investment risk frequently consider this strategy. While this approach might help you better manage risk, you are less likely to have outsized returns. There are pros and cons to dollar-cost averaging that can help investors determine if it is the right investment strategy for them.
Key Takeaways
- Dollar-cost averaging is the practice of investing a consistent dollar amount in the same investment on a regular basis.
- The dollar-cost averaging method reduces investment risk, but it is less likely to result in outsized returns.
- The advantages of dollar-cost averaging include reducing emotional reactions and minimizing the impact of bad market timing.
- A disadvantage of dollar-cost averaging includes missing out on higher returns over the long term.
How to Dollar-Cost Average
Dollar-cost averaging is pretty simple. Pick a stock, fund, or other asset; then decide on a fixed amount to invest in it regularly. With dollar-cost averaging, you invest a set amount in the same asset at regular intervals, such as once a month or every payday. It doesn’t matter what the price of the investment is. You keep adding to your holding whether its valuation is up or down.
If you have a401(k) retirement plan, you're already using the dollar-cost averaging strategy.
There are two ways to dollar-cost average: manually or automatically. Doing it manually requires going to your broker in person or online each time the date arrives to add to your holding. Opting for automatic investments is generally a better idea. It will simplify the process, establish an investing habit, and prevent you from missing a transaction. Most brokers facilitate automatic buying plans.
Remember: The amount you purchase will vary depending on price changes in the market. For example, if you invest in a company and its share price rises, the next time you add to your holdings, the same amount of money will buy fewer shares. The same logic applies if the share price falls.
Example of Dollar-Cost Averaging
You might be interested in buying XYZ stock but don’t want to take the risk of investing your money all at once. Instead, you could invest a steady amount, say $300, every month.
If the stock trades at $10 in a given month, you will buy 30 shares. If it later goes up to $12, you will end up purchasing 25 shares that month. And if the price falls to $8 the next month, you’ll get 37 shares. If you stick to this strategy over the long term, you’ll put a constant dollar amount every month into a specific allocation of investments, thereby reducing the impact of market volatility.
When Should You Use Dollar-Cost Averaging?
Dollar-cost averaging is designed for investors in it for the long haul who adopt a buy-and-hold strategy. You need to have a lot of patience and be convinced about the chosen asset’s long-term prospects.
Dollar-cost averaging suits people investing for the long term, who don't have a large lump sum to invest all at once, or who don't want to worry about getting the timing right.
Investors using this strategy generally don’t have a large lump sum to invest. Instead, they make do by adding any excess money they have to their portfolio each week or month. That said, dollar-cost averaging could also appeal to novice investors who don’t have the experience or expertise to judge the best timing for buying investment vehicles.
Trying to time the market is one of the major challenges investors face, and even professionals rarely get it right. Many make the wrong calls and lose money or become too afraid of the risk and simply refrain from investing. With dollar-cost averaging, you remove the stress of making this decision.
Pros and Cons of Dollar-Cost Averaging
Pros
Reduces emotional decision-making
Avoids the challenge of trying to time the market
Cons
The market tends to rise over time, so investing earlier is better
Not a substitute for identifying good investments
Pros of Dollar-Cost Averaging
Reduces emotional investing
One advantage of dollar-cost averaging is that you take the emotional component out of your decision-making by automatically investing. You continue on a preset course, buying a certain dollar amount of your preferred investment no matter how wildly the price fluctuates over time. This way, you won't bail on your investment when the price drops suddenly. Instead, you could see it as a chance to acquire more shares at a lower cost.
Minimizes the impact of bad timing
It is almost always impossible to determine a market bottom, which is why dollar-cost averaging can help smooth out how fluctuations in the market affect your portfolio.
If you invest your money all at once in a particular asset, you risk investing right before a market downturn. Imagine you'd invested just before themarket downturn that began in 2007. You would have lost more money than if you had invested only some of your money before then.
Of course, this also means you might miss investing a large amount of money at just the right time before the market starts trending upward in a bull market. But because "timing the market" is so challenging, dollar-cost averaging can be a more practical approach that minimizes the impact of market volatility.
Cons of Dollar-Cost Averaging
The market rises over time
One disadvantage of dollar-cost averaging is that the market tends to go up over time. Thus, investing a lump sum earlier is likely to do better than investing smaller amounts over a long period of time.
For example, suppose you had invested $10,000 all at once in a stock that goes up about 10% annually at the beginning of a 10-year period. That's better financially than investing the same amount more slowly over that time, say $1,000 per year.
If you took the slow-but-steady approach, you would earn $7,531.17 on your investment, inflation and fees aside. But if you invested the initial lump sum, you would have earned $15,937.42. That said, if a stock turns south soon after you begin investing and you don't put more money after bad, you would lose less than in the lump-sum scenario.
Not a substitute for identifying good investments
Dollar-cost averaging is not a solution for all investment risks. You will still have to identify good investments and do your research, even if you opt for the passive dollar-cost averaging approach. If the asset you identify is a bad pick, you will only be investing steadily into a losing investment.
By adopting a passive approach, you will not respond to fluctuations in the market, good or bad. As the investment environment changes, you might get new information about an investment that makes you rethink your approach.
For instance, if you hear that XYZ company is making an acquisition that will add to its earnings, you might increase your investment in the company. However, a dollar-cost averaging approach does not allow for that sort of dynamic portfolio management.
What Is Compound Interest?
When savings are invested, they hopefully generate interest income. This income then earns interest. This is known as compound interest and can make a huge difference over time when dollar-cost averaging. Suppose you invest $1,000 in a savings account with a 5% annual interest rate. After the first year, you'd earn $50 in interest, bringing your total balance to $1,050. In the second year, you'd earn interest not just on your initial $1,000 but also on the $50 interest from the first year. So, your interest for the second year would be $52.50 ($1,050 x 5%), bringing your total balance to $1,102.50. This compounding effect can significantly boost your portfolio as the years go by.
How Does Dollar-Cost Averaging Compare to Lump-Sum Investing?
With lump-sum investing, you invest a lump sum all at once rather than gradually at regular intervals. Lump-sum investing can generate higher returns as the initial larger sum of money has more time to grow. With dollar cost averaging, you are hopefully, growing the initial amount into a larger amount over time. However, there are also benefits to dollar-cost averaging. Dollar-cost averaging provides a means for people who don't have a lump sum but have regular excess cash to invest immediately, removing the daunting prospect of getting the timing right.
How Does Dollar-Cost Averaging Work in a Volatile Market?
In a market with major price swings, dollar-cost averaging can be particularly useful, in part because it allows you to ignore the emotional highs and lows of watching the market and trying to time your trades perfectly. When prices are down, your set investment buys more shares; when they are up, you get fewer shares. Over time, this avoids the fees of trading frequently at volatile moments or allowing your emotions to get the best of you at a market low.
The Bottom Line
If you are a less experienced investor or want to follow a consistent investing strategy, so you're less exposed to wild market swings, dollar-cost averaging could be a good approach. Alternatively, if you are an experienced investor, you might get better returns by active strategizing, instead of using this passive strategy.
