What Is Dollar-Cost Averaging?
Investing can be challenging. Even experienced investors who try to time the market to buy at the most opportune moments can come up short.
Dollar-cost averaging is a strategy that can make it easier to deal with uncertain markets by making purchases automatic. It also supports an investor's effort to invest regularly.
Dollar-cost averaging involves investing the same amount of money in a target security at regular intervals over a certain period of time, regardless of price. By using dollar-cost averaging, investors may lower their average cost per share and reduce the impact of volatility on the their portfolios.
In effect, this strategy eliminates the effort required to attempt to time the market to buy at the best prices.
Dollar-cost averaging is also known as the constant dollar plan.
Key Takeaways
- Dollar-cost averaging is the practice of systematically investing equal amounts of money at regular intervals, regardless of the price of a security.
- Dollar-cost averaging can reduce the overall impact of price volatility and lower the average cost per share.
- By buying regularly in up and down markets, investors buy more shares at lower prices and fewer shares at higher prices.
- Dollar-cost averaging aims to prevent a poorly timed lump sum investment at a potentially higher price.
- Beginning and long-time investors can both benefit from dollar-cost averaging.
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How Dollar-Cost Averaging Works
Dollar-cost averaging is a simple tool that an investor can use to build savings and wealth over the long term. It is also a way for an investor to ignore short-term volatility in the broader markets.
A prime example of long-term dollar-cost averaging is its use in 401(k) plans, in which employees invest regularly regardless of the price of the investment.
With a 401(k) plan, employees can choose the amount they wish to contribute as well as those investments offered by the plan in which to invest. Then, investments are made automatically every pay period. Depending on the markets, employees might see a larger or smaller number securities added to their accounts.
Dollar-cost averaging can also be used outside of 401(k) plans. For instance, investors can use it to make regular purchases of mutual or index funds, whether in another tax-advantaged account such as a traditional IRA or a taxable brokerage account.
Dollar-cost averaging is one of the best strategies for beginning investors looking to trade ETFs. Additionally, many dividend reinvestment plans allow investors to dollar-cost average by making purchases regularly.
Benefits of Dollar-Cost Averaging
- Dollar cost averaging can lower the average amount you spend on investments.
- It reinforces the practice of investing regularly to build wealth over time.
- It's automatic and can take concerns about when to invest out of your hands.
- It removes the pitfalls of market timing, such as buying only when prices have already risen.
- It can ensure that you're already in the market and ready to buy when events send prices higher.
- It takes emotion out of your investing and prevents you from potentially damaging your portfolio's returns.
Who Should Use Dollar-Cost Averaging?
The investment strategy of dollar-cost averaging can be used by any investor who wants to take advantage of its benefits, which include a potentially lower average cost, automatic investing over regular intervals of time, and a method that relieves them of the stress of having to make purchase decisions under pressure when the market is volatile.
Dollar-cost averaging may be especially useful to beginning investors who don't yet have the experience or expertise to judge the most opportune moments to buy.
It can also be a reliable strategy for long-term investors who are committed to investing regularly but don't have the time or inclination to watch the market and time their orders.
However, dollar-cost averaging isn't for everyone. It isn't necessarily appropriate for those investing time periods when prices are trending steadily in one direction or the other. Be sure to consider your outlook for an investment plus the broader market when making the decision to use dollar-cost averaging.
Bear in mind that the repeated investing called for by dollar-cost averaging may result in higher transaction costs compared to investing a lump sum of money once.
Special Considerations
It's important to note that dollar-cost averaging works well as a method of buying an investment over a specific period of time when the price fluctuates up and down. If the price rises continuously, those using dollar-cost averaging end up buying fewer shares. If it declines continuously, they may continue buying when they should be on the sidelines.
So, the strategy cannot protect investors against the risk of declining market prices. Like the outlook of many long-term investors, the strategy assumes that prices, though they may drop at times, will ultimately rise.
Using this strategy to buy an individual stock without researching a company's details could prove detrimental, as well. That's because an investor might continue to buy more stock when they otherwise would stop buying or exit the position.
For less-informed investors, the strategy is far less risky when used to buy index funds rather than individual stocks.
Investors who use a dollar-cost averaging strategy will generally lower their cost basis in an investment over time. The lower cost basis will lead to less of a loss on investments that decline in price and generate greater gains on investments that increase in price.
Example of Dollar-Cost Averaging
Joe works at ABC Corp. and has a 401(k) plan. He receives a paycheck of $1,000 every two weeks. Joe decides to allocate 10% or $100 of his pay to his employer’s plan every pay period.
He chooses to contribute 50% of his allocation to a large cap mutual fund and 50% to an index fund. Every two weeks 10%, or $100, of Joe’s pre-tax pay will buy $50 worth of each of these two funds regardless of the fund's price.
The table below shows the half of Joe's $100 contributions that went to the S&P 500 index fund over 10 pay periods. Throughout 10 paychecks, Joe invested a total of $500, or $50 per week. The price of the fund increased and decreased over that time.
The results of dollar-cost averaging:
Joe spent $500 in total over the 10 pay periods and bought 47.71 shares.
He paid an average price of $10.48 ($500/47.71).
Joe bought different share amounts as the index fund increased and decreased in value due to market fluctuations.
The results if Joe spent one lump sum:
Say that, instead of using dollar-cost averaging, Joe spent his $500 at one time in pay period 4. He paid $11 per share.
That would have resulted in a purchase of 45.45 shares ($500/$11).
There was no way for Joe to know the best time to buy. By using dollar-cost averaging, though, he was able to take advantage of several price drops despite the fact that the share price increased to over $11. He ended up with more shares (47.71) at a lower average price ($10.48).
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Is Dollar-Cost Averaging a Good Idea?
It can be. When dollar-cost averaging, you invest the same amount at regular intervals and by doing so, hopefully lower your average purchase price. You will already be in the market when prices drop and when they rise. For instance, you'll have exposure to dips when they happen and don't have to try to time them. By investing a fixed amount regularly, you will end up buying more shares when the price is lower than when it is higher.
Why Do Some Investors Use Dollar-Cost Averaging?
The key advantage of dollar-cost averaging is that it reduces the negative effects of investor psychology and market timing on a portfolio. By committing to a dollar-cost averaging approach, investors avoid the risk that they will make counter-productive decisions out of greed or fear, such as buying more when prices are rising or panic-selling when prices decline. Instead, dollar-cost averaging forces investors to focus on contributing a set amount of money each period while ignoring the price of the target security.
How Often Should You Invest With Dollar-Cost Averaging?
With regard to actually using the strategy, how often you use it may depend on your investment horizon, outlook on the market, and experience with investing. If your outlook is for a market in flux that will eventually rise, then you might try it. If a persistent bear market's at work, then it wouldn't be a smart strategy to use. If you're planning to use it for long-term investing and wonder what interval for buying makes sense, consider applying some of every paycheck to the regular purchases.
