“Buy low, sell high” is common advice among investors — but timing the market can be a full-time job. No one knows what the market is going to do from one hour or one day to the next, and investors can lose a lot of time, energy and money trying to guess. That’s where dollar-cost averaging comes in.
What is dollar-cost averaging? It’s an investment strategy where you dedicate a consistent amount of money toward your investments on a regular basis. When you do this, you sometimes buy low and other times, at a high. The idea is that your average price point equalizes over time.
How Dollar-Cost Averaging Works
As an investor, you want your money to go as far as possible. For example, let’s say you have $600 to invest. You’ve done your research and decided on an investment, such as a balanced mutual fund with a strong history of solid returns and a low expense ratio.
The amount of money you’re going to put into that fund — $600 — will not change, but the price per share of your investment of choice will as the market moves up and down. These fluctuations mean that your $600 will purchase fewer shares if you buy when your chosen fund is at a higher price, or it will buy more shares if you purchase when the fund’s price is lower.
Here’s a look at how your purchases might break down over the course of a year:
| Month | Amount To Invest | Share Price | Shares Purchased |
|---|---|---|---|
| January | $50 | $7 | 7.14 |
| February | $50 | $9 | 5.55 |
| March | $50 | $12 | 4.17 |
| April | $50 | $10 | 5 |
| May | $50 | $8 | 6.25 |
| June | $50 | $11 | 4.54 |
| July | $50 | $13 | 3.85 |
| August | $50 | $7 | 7.14 |
| September | $50 | $9 | 5.55 |
| October | $50 | $10 | 5 |
| November | $50 | $12 | 4.17 |
| December | $50 | $8 | 6.25 |
Since the share price varied throughout the year, you were able to buy more shares some months and fewer shares in others.
- If you had spent your entire $600 when the share price was at its lowest — $7 — you would have purchased 85.71 shares.
- If you had spent your entire $600 when the share price was at its highest — $13 — you would have purchased 46.15 shares.
- By dollar-cost averaging, or making a consistent investment of $50 each month, you would have ended up with 64.61 shares. That’s near the middle point between buying low and buying high.
You can feel confident that you made your $600 stretch as far as possible without having to be glued to daily market news, vigilantly watching for ups and downs.
Benefits of Dollar-Cost Averaging
Before you decide how to spend your investment dollars, you should consider the benefits.
- Removes emotions from your investment strategy.
- Helps prevent investing all your money at a market peak.
- Allows you to buy more shares when prices drop.
- Provides you with a long-term average cost.
Potential Downsides of Dollar-Cost Averaging
Every investment strategy carries some risk. Here are some potential drawbacks to this strategy:
- Can keep compounding losses if you invest in a security that never rises.
- Potential for more fees if you make multiple transactions instead of a lump sum.
- Can complicate taxes when you sell.
- If you’re starting with a lump sum of money, you could risk missing gains if you invest it over time instead of all at once.
Benefits and Challenges of Dollar-Cost Averaging at a Glance
| Pros | Cons |
|---|---|
| Removes emotional decision-making from investing | Can accumulate losses if investing in a declining asset |
| Helps avoid investing at market peak | Might miss out on larger gains from lump-sum investing |
| Takes advantage of market dips to buy more shares | Potentially higher transaction fees with multiple purchases |
| Creates a disciplined long-term investing habit | Can complicate tax calculations when selling assets |
When Is Dollar-Cost Averaging Best Used?
Anyone can use dollar-cost averaging to try and grow their wealth, but it can be a particularly good fit for the following individuals.
Investors Tempted To Try For a Quick Buck
If the desire to hustle runs through your veins, then you are vulnerable to hasty decision-making as the market goes up and down. This approach can get you interested in edgy companies with the potential to be the market’s next lightning bolt, rather than more stable investments.
You can also lose a lot of money by buying and selling during market swings, even if you intend to use them to your advantage.
Investors Prone to Fear
On the opposite side of the coin, fearful investors are equally vulnerable. You may find yourself sitting on your cash, unwilling to wade into the market. If you do invest, you could be prone to panic during market lows. If you sell before you’ve owned an investment asset for less than a year, you may face higher taxes on any capital gains.
The amount of time your investments spend in the market matters, so it’s important to keep fear in check. Volatility can actually be an ally for an investor who uses dollar-cost averaging. The more often the market dips, the more likely that your regular contributions will be picking up shares at cheaper prices. This can actually provide bigger long-term gains for the dollar-cost-averaging investor than if the market just continually moves slowly higher.
Would-Be Investors With Impostor Syndrome
Generally, the most vulnerable investors of all are the ones who never wade in. Investing is scary for many people, and they don’t typically learn about it at home or school. If this is you, there’s no shame in that, but dollar-cost averaging could be a comfortable way for you to begin investing.
Financially speaking, there’s no better friend than compound interest or the momentum that your investments gain over time. Although investing always carries some risk, there are ways to invest that help minimize that risk and provide the strongest opportunity for your wealth to grow gradually.
Dollar-Cost Averaging vs. Lump Sum Investing
Both dollar-cost averaging and lump-sum investing have advantages and the best choice depends on an investor’s risk tolerance and financial situation.
- Dollar-cost averaging: Spreads investments out over time. This reduces the risk of investing all funds at a market high. Useful for volatile markets and for investors who do not want to monitor prices constantly.
- Lump-sump investing: Invest all available capital at once. Can generate higher long-term returns if the market trends up. Carries more risk in the short term.
Common Mistakes To Avoid With Dollar-Cost Averaging
Even though dollar-cost averaging is a simple strategy, there are a few mistakes to watch out for:
- Not sticking to the plan: Skipping contributions can reduce the long-term benefits.
- Ignoring investment quality: Dollar-cost averaging works best with strong investments — buying into declining assets won’t help in the long run.
- Overlooking fees: Frequent trades can add up, especially if your brokerage charges transaction fees.
How To Start Using Dollar-Cost Averaging
If you’re sold on this strategy but not sure how to begin, here’s some guidance.
1. Pick an Investment Vehicle
This could be a 401(k), an IRA or a brokerage account that you direct money to regularly.
2. Choose a Frequency
In some investment vehicles, such as a 401(k), the frequency of your contributions is preset to every pay cycle. If you’re going to use dollar-cost averaging to direct funds to an IRA or a brokerage account, then you’re in charge of how frequent your contribution is. You may choose daily, weekly or monthly.
3. Set Your Contribution and Forget It
Figure out how much you can afford to dedicate to your chosen investment. Does 5% of your net income work? How about 10%?
Make sure that the amount you choose is going to work, given the frequency of your contribution. This is the investment strategy that people often refer to as “set it and forget it.”
4. Consider Increasing Your Contributions Over Time
Once you’ve gotten in the habit of making regular contributions to your investment account, try to slowly raise the amount you allocate every year, or even every month if you’re ambitious.
If you start by saving 5% of your salary in your 401(k) plan, for example, try bumping that up to 6%. After a few months you’ll likely not even notice the additional money that you’re taking out of your paycheck. But these slight, regular bumps in your contribution rate can make a big difference over the long run when it comes to the size of your nest egg.
Key Takeaways
Here are a few points to keep in mind when considering this strategy:
- If you have a 401(k) at work, you may already be using dollar-cost averaging.
- Dollar-cost averaging provides you with a steady way to invest over time.
- When you invest the same amount consistently, you don’t have to worry about timing the market.
No matter how you decide to invest, the consistency that dollar-cost averaging brings to your financial life is an asset in and of itself. When you invest steadily over time, you buy at both ups and downs. This leaves you in the best position possible for growth without having to fixate on market fluctuations. That’s bound to be a reassurance for any investor.
FAQ
Here are the answers to some of the most frequently asked questions about dollar-cost averaging and how it works.- Is dollar-cost averaging suitable for beginners?
- It can be an excellent investing strategy for beginners since it removes the stress of market timing. It also helps build long-term investment habits.
- Can DCA work for retirement accounts?
- Absolutely. Many retirement accounts, such as 401(k) plans and IRAs, automatically use DCA when investors make regular contributions from their paychecks.
- How does DCA affect investment returns in the long run?
- Dollar-cost averaging spreads your investments over time. Instead of worrying about buying at the "right" money, you invest the same amount regularly -- sometimes at higher prices, sometimes at lower ones. Over time, this balances out the cost of your investments and reduces the risk of a bad buy when prices are high.
- Can you use DCA for individual stocks or only mutual funds?
- DCA can be used for both but it's often recommended for diversified portfolios containing ETFs and mutual funds. Using DCA for individual stocks is riskier because of company-specific volatility.
John Csiszar contributed to the reporting for this article.