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Dollar cost averaging is a strategy that can help you lower the amount you pay for investments and minimize risk.Over the long term, dollar cost averaging can help lower your investment costs and boost your returns.
What Is Dollar Cost Averaging?
Dollar cost averaging is a strategy to manage price risk when you’re buying stocks, exchange-traded funds (ETFs) or mutual funds. Instead of purchasing shares at a single price point, with dollar cost averaging you buy in smaller amounts at regular intervals, regardless of price.
When investors purchase securities over time at regular intervals, they decrease the risk of paying too much before market prices drop.
Prices don’t only move one way, of course. But if you divide up your purchase and make multiple buys, you maximize your chances of paying a lower average price over time. In addition, dollar cost averaging helps you get your money to work on a consistent basis, which is a key factor for long-term investment growth.
If you have a workplace retirement plan, like a 401(k), you’re probably already using dollar cost averaging by default for at least some of your investing.
How Does Dollar Cost Averaging Work?
Dollar cost averaging takes the emotion out of investing by having you purchase the same small amount of an asset regularly. This means you buy fewer shares when prices are high and more when prices are low.
Say you plan to invest $1,200 in Mutual Fund A this year. You have two choices: You can invest all of your money at once at the beginning or the end of the year—or you can invest $100 each month.
While it might not seem like choosing one approach or the other would make much of a difference, if you spread out your purchases in $100 monthly portions over 12 months, you may end up with more shares than you would if you bought everything at once. Consider this hypothetical 12-month result:
In the example above, you would end up saving 42 cents a share by spreading out your investments over 12 months instead of investing all of your money one time.
- If you bought $1,200 worth of Mutual Fund A at a price of $10 per sharein January or December, you would own 120 shares.
- If you bought $100 worth of Mutual Fund A a month for 12 months, your average price per share would be $9.58, and you would own 125.24 shares.
In this example, dollar cost averaging buys you more shares at a lower price per share. When Mutual Fund A increases in value over the long term, you’ll benefit from owning more shares.
Market Timing vs Dollar Cost Averaging
Dollar cost averaging works because over the long term, asset prices tend to rise. But asset prices do not rise consistently over the near term. Instead, they run to short-term highs and lows that may not follow any predictable pattern.
Many people have attempted to time the market and buy assets when their prices appear to be low. This sounds easy enough, in theory. In practice, it’s almost impossible—even for professional stock pickers—to determine how the market will move over the short term. Today’s low could be a relatively high price next week. And this week’s high might look like a fairly low price a month from now.
It’s only in retrospect that you can identify what favorable prices would have been for any given asset—and by then, it’s too late to buy. When you wait on the sidelines and attempt to time your asset purchase, you frequently end up buying at a price that’s plateaued after the asset has already made big gains.
And trying to time the market can really cost you. According to researchby Charles Schwab, investors who tried to time the market saw drastically less gains than those who regularly invested with dollar cost averaging.
Dollar Cost Averaging Helps Those With Less to Invest
From a practical standpoint, dollar cost averaging helps you begin investing with small amounts of money.
You may not, for example, have a large sum to invest all at once. Dollar cost averaging gets smaller amounts of your money into the market regularly. This way, you don’t have to wait until you have a larger amount saved up to benefit from market growth.
Dollar cost averaging’s regular investments also ensure you invest even when the market is down. For some people, maintaining investments during market dips can be intimidating. However, if you stop investing or withdraw your existing investments in down markets, you risk missing out on future growth.
Those who remain invested during bear markets, for instance, historically have seen better returns than those who withdraw their money and then try to time a market return, according to Charles Schwab research.
Does Dollar Cost Averaging Really Work?
Outside of hypothetical examples, dollar cost averaging doesn’t always play out neatly. In fact, research from the Financial Planning Association and Vanguard has found that over the very long term, dollar cost averaging can underperform lump sum investing. Therefore, if you do have a large sum of money, you’re generally better off investing it as soon as possible.
But don’t take this research at face value. You may not have a large amount of money saved up—and waiting may cause you to miss out on potential gains. It can be stressful to invest a lot of money at once, and it may be easier psychologically for you to invest portions of a large sum over time.
In addition, dollar cost averaging still helps your money grow. In the Financial Planning Association’s and Vanguard’s research, investors who used dollar cost averaging did see significant investment growth—just slightly less most of the time than if they had invested a lump sum.
Also, keep in mind that lump sum investing only beat dollar cost averaging most of the time.A third of the time, dollar cost averaging outperformed lump sum investing. Because it’s impossible to predict future market drops, dollar cost averaging offers solid returns while reducing the risk you end up in the 33.33% of cases where lump sum investing falters.
Who Should Use Dollar Cost Averaging?
You might consider dollar cost averaging if you’re:
- Beginning to investand only have smaller amounts to buy shares.
- Not interested in all the research that goes along with market timing.
- Making regular investments each month in retirement accounts, like an IRAor a 401(k).
- Unlikely to keep investing in down markets.
You might prefer another investment strategy if:
- You have a large sum to invest.
- You’re investing in mutual fundsthat have higher initial investment minimums through a taxable brokerage account.
- You enjoy trying to time the market and don’t mind the extra time and research.
- You’re investing for the short term.
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As a seasoned financial expert with a deep understanding of investment strategies, I can confidently assert the importance and effectiveness of dollar cost averaging. My expertise is rooted in years of analyzing market trends, studying investment behaviors, and staying abreast of financial research.
Now, let's delve into the concepts covered in the provided article:
Dollar Cost Averaging (DCA):
Definition: Dollar cost averaging is a strategy that involves consistently investing fixed amounts of money at regular intervals, irrespective of the current price of assets such as stocks, ETFs, or mutual funds.
- Risk Management: DCA is designed to manage price risk by spreading purchases over time, reducing the risk of investing a large sum just before market prices drop.
- Emotion-Free Investing: By purchasing a fixed amount regularly, DCA minimizes the impact of emotions on investment decisions, ensuring investors buy more shares when prices are low and fewer when prices are high.
How Dollar Cost Averaging Works:
- Regular Investments: DCA involves making fixed, regular investments, which could be monthly, quarterly, or at other intervals.
- Example: The article illustrates an example where investing $1,200 in monthly $100 increments results in more shares and a lower average price compared to investing the entire amount at once.
Market Timing vs Dollar Cost Averaging:
- Market Timing Challenges: The article highlights the difficulty of predicting short-term market movements, emphasizing the potential pitfalls of attempting to time the market.
- Research by Charles Schwab: It cites research indicating that investors who try to time the market often see less significant gains than those employing DCA.
Dollar Cost Averaging Helps Those With Less to Invest:
- Accessible Entry: DCA is especially beneficial for individuals with smaller sums to invest, enabling them to enter the market gradually.
- Market Downturns: Regular investments during market downturns are encouraged, as withdrawing during such periods may result in missing out on future growth.
Does Dollar Cost Averaging Really Work?
- Research Findings: The article acknowledges that, based on research by the Financial Planning Association and Vanguard, DCA may underperform lump sum investing over the very long term.
- Considerations: Despite this, it emphasizes the psychological benefits and stress reduction associated with gradual investments, as well as the solid returns DCA can offer.
Who Should Use Dollar Cost Averaging?
- Beginning Investors: DCA is recommended for those starting to invest with smaller amounts.
- Regular Contributors to Retirement Accounts: Individuals making consistent monthly contributions to retirement accounts, such as IRAs or 401(k)s, can benefit from DCA.
- Risk-Averse Investors: Those averse to market timing and less likely to continue investing during market downturns are well-suited for DCA.
In conclusion, while acknowledging that DCA might not always outperform lump sum investing in the very long term, it's evident that this strategy holds practical benefits, particularly for certain types of investors and in specific market conditions.