- Dollar-cost averaging is an investment strategy that can help you pay less for investments.
- You'll invest a fixed dollar amount at regular intervals over a long period.
- Dollar-cost averaging may underperform lump-sum investing in certain cases.
Investing is all about managing risk and reward. The stock market is well-known for its ups and downs and trying to "time the market" can be difficult, especially if you're just getting started with investing.
Instead of trying to time the market, there's an alternative strategy that can be beneficial for investors at all levels: dollar-cost averaging.
Is dollar-cost averaging worth it? This article will give you the information you need to answer that question, reviewing the benefits of this particular strategy and assessing the alternative.
What is dollar-cost averaging?
Understanding dollar-cost averaging (DCA)
Dollar-cost averaging is a strategy you can use to smooth out volatility and lower your cost basis for investments. Basically, this approach is the exact opposite of trying to "time the market," as it typically involves investing the same amount at regular intervals, regardless of whether prices are up or down.
The amount you invest, as well as how often you do so, can vary depending on the investor. By consistently putting money into the same investment over a period of time, you're able to buy more shares during the dips and buy fewer when prices are high — basically leveling things out and reducing risk amid any volatility.
"Dollar-cost averaging is an investment strategy that basically helps smooth out the cost of investing and minimizes the associated risk of trying to time the market," explains Sabrina Maria LaFleur, CFO, AfriCaribbean Trade and Logistics Consulting Group and former lead planner and CFP at LearnLux.
Investing set amounts at regular intervals
Dollar-cost averaging is a way for investors to continue to put money into the market regardless of the ups and downs it is experiencing. Through dollar-cost averaging, investors put in the same amount of money at regular intervals (monthly, quarterly, etc.) in order to build wealth over time.
Instead of focusing on the ins and outs of "timing the market," or making predictions on price movements, dollar-cost averaging is about consistently putting money into the market despite any gains or losses.
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Dollar-cost averaging has two major components:
- The fixed amount you invest
- How often you invest that amount
"The way it works is you purchase a fixed amount of the same investment in strategic intervals, like $100 on the first of each month. When you continue the strategy over an extended period of time, you should find that you're able to purchase more shares with that $100 in some months than in other months because the price of shares will likely have fluctuated during your investment period," notes LaFleur.
You could be utilizing dollar-cost averaging already and not even be aware of it. For instance, a common example of dollar-cost averaging is an employee who invests regularly in their 401(k). With every paycheck, a fixed amount or salary percentage goes into your retirement account and you automatically buy the investment funds you've previously selected.
Dollar-cost averaging typically works well because it's about consistently funding your investments and putting money into the market so you can build wealth over time, rather than holding off on investing and attempting to time the market, which can lead to lower allocations and/or missed opportunities, like not being invested during market rallies.
Dollar-cost averaging is "probably the most effective strategy for all investors at all levels. It's one of the best ways to set it and forget it, but you do want to pay attention to what you're investing in," says LaFleur.
Dollar-cost averaging example: Investing $100 every month
There are many dollar-cost averaging examples that help show the efficacy of this strategy. Here is a relatively straightforward one we will use for the sake of simplicity.
Let's say you decide to invest $100 per month in an index fund that's trading at $20 per share. That means the first month, you'd be able to purchase five shares for $100 total. The next month, when you have another $100 to invest, the price soars to $50 per share and you'd be able to purchase only two shares. After a market drop in the third month, the price is down to $10 per share and you'd be able to buy 10 shares. In a three-month period, you'd invest $300 and have 17 shares. Here's a breakdown:
| Time | Amount invested | Share price in the market | # of shares bought that month | Total shares |
| Month 1 | $100 | $20 | 5 | 5 |
| Month 2 | $100 | $50 | 2 | 7 |
| Month 3 | $100 | $10 | 10 | 17 |
In this example, even with price fluctuations over the three months, at $300 invested with 17 shares, your average cost per share is $17.65 ($300 ÷ 17 = $17.65).
If you were to sell in month four at a $20 share price (the same price as month one), you'd sell your 17 shares for $340, with a profit of $40.
In comparison, suppose you tried to time the market. Maybe you saw the share price rise from $20 to $50 and decided to try to jump in then to try to catch the rising tide by investing $300 to buy six shares. Then, if you sold when the stock fell to $10 in Month 3, you would have sold those six shares for only $60, meaning you lost $240.
This exemplifies the perils of trying to time the market. Of course, it's possible to time it well, such as buying in at $10 and selling at $20 per share, but no one knows when that will actually happen. Study after study shows that on average, trying to time the market is a losing proposition. You might get lucky, but odds are, you'll miss out more than if you dollar cost averaged.
While dollar-cost averaging won out in this hypothetical scenario, that won't always be the case. Yes, dollar-cost averaging is a good strategy for managing risk and potentially lowering the average amount you pay for shares.
But there's a strong case for lump-sum investing, which exposes you to the market sooner and has been found to be more beneficial as a strategy.
A study done by Northwestern Mutual found that lump-sum investing generated better cumulative returns at the end of 10 years than dollar-cost averaging almost 75% of the time, regardless of asset allocation.
Using dollar-cost averaging, your cost-per-share may even out and be lower, but you may also get weaker returns. Through lump-sum investing, you may pay more per share but expose your money to the market which can lead to higher returns but also more risk. In this way, dollar-cost averaging may be a safer bet for people with a low risk tolerance.
Dollar cost-averaging vs. lump-sum investing
However, an alternative to dollar-cost averaging is lump-sum investing, where you put all your money in at once, like investing a tax refund right away rather than spreading it out over time. This approach often beats dollar-cost averaging, because it exposes you to the market sooner, meaning you have more time in the market vs. timing the market.
For example, a study done by Northwestern Mutual found that lump-sum investing generated better cumulative returns at the end of 10 years than dollar-cost averaging almost 75% of the time, regardless of asset allocation.
In other words, if you're using dollar-cost averaging as a way to try to time the market to some extent, e.g., spreading out your investment because you think the market is too high right now, that can be risky. But it can make sense at other times, like if you're allocating a portion of each paycheck to investments, rather than saving that money and deciding to invest a lump sum much further down the line, giving you less time in the market.
Why dollar-cost average?
Dollar cost-averaging is used for investing in many ways — some for risk management purposes, some for practical purposes like automatically investing in retirement accounts. Specifically, some of the top benefits of dollar-cost averaging include the following:
Reduces timing risk
Using dollar-cost averaging reduces market timing risk, which is the risk associated with attempting to take advantage of highs and lows in the market, which are notoriously difficult to predict.
Potential for lower average purchase price
Another major draw of dollar-cost averaging is that it can reduce the average price you pay for the assets you purchase. The example used earlier in this article is a good way to illustrate this potential benefit.
Buying shares of companies at a lower price than you would otherwise can result in greater returns when you decide to sell these assets later on.
Disciplined investing
Dollar-cost averaging can help investors remain consistent in their quest to build wealth and can combat fear over volatility. Whatever your chosen dollar cost averaging frequency is, such as allocating $100 once per month, that's what you invest, regardless of what's happening in the market. Staying the course like this can help over the long term, as you continue to invest and avoid panic selling. In contrast, when investors are fearful, it can lead to poor decision-making.
"The upside is when the market is down the share price of the investments you're purchasing are likely to be down as well, which means you're buying it at a discount or when the shares are 'on sale.' This basically allows you to purchase more with your money without trying to time the market, which is often a losing strategy," says LaFleur.
Important considerations
Dollar-cost averaging is helpful for investors who may not have as much money to invest. You may think you need thousands of dollars to get started with investing, but you don't. While a lump-sum investor may use that strategy after receiving a windfall like an inheritance, using dollar-cost averaging, you can invest a smaller amount in regular intervals to build wealth over time.
In other words, dollar-cost averaging is a good strategy for investors who may not have tons of cash to invest right away and people who don't want to concern themselves with the ups and downs of the market. Investing small amounts over time to take advantage of price dips, or simply using dollar cost averaging to keep you investing on a consistent basis, could lead to more money years down the road than if you tried to set money aside in a savings account and tried to invest later on.
If you don't trust yourself to stay the course with your investments, the best dollar-cost averaging strategy could be to set up automatic investments and then try not to look at the day-to-day swings. Instead, keep letting those automatic investments happen and don't worry about trying to perfect your timing; otherwise, you might sell in a panic and potentially lose out on important gains in the long run.
That said, if you have a large sum of cash to invest now, or you're willing to take the risk of trying to time the market, lump sum investing may be a good fit.
As noted above, dollar-cost averaging may offer lower returns than lump-sum investing. Additionally, when prices are high you may get less bang for your buck by using dollar-cost averaging.
"The main disadvantage is that when the market is up the share price of the investments you're purchasing are likely to go up as well which means you're buying at a premium," says LaFleur. "This is not necessarily a bad thing. This strategy ensures you're still participating in long-term market growth by investing what you can regardless of market conditions instead of allowing emotion to drive your investment decisions."
Another thing to consider is that through dollar-cost averaging you could end up dealing with more transaction fees, like brokerage trading fees, which could take a chunk out of your nest egg. However, many of the best brokerages nowadays have free or low-cost trading, so this is less of a concern than it used to be. As always, though, be sure to research fees such as transaction costs and fund management fees as part of your investment planning.
How to start dollar-cost averaging
Choose your investment (stocks, ETFs, etc.)
If you want to take part in dollar-cost averaging, the first step is to select the security you want to invest in. This could be shares of stock in a particular company like Apple, for example, or an exchange-traded fund (ETF), a security that can quickly offer broader exposure to many different assets, such as by tracking the S&P 500 index, which is composed of around 500 large U.S. companies.
Select a broker or platform
The next step in dollar-cost averaging is selecting a brokerage or platform for making transactions. There are countless options on this front, offering a wide range of services such as zero-commission trades or transactions assisted by financial professionals.
Set up automatic contributions
The next step in dollar-cost averaging is determining how much you want to invest and how often you are going to make that contribution. For instance, you could put $100 toward this strategy every month like the example used earlier in this article.
Alternatively, you could use a higher monthly amount if you want to build wealth more aggressively. In addition, you could choose a different interval, putting away money once a week, or once a quarter, for example.
Regardless of what amount and frequency you select, the important part is to stick with it, which is where setting up an automatic investing schedule comes in handy. That way, you can consistently benefit from the strategy of dollar-cost averaging by buying your underlying asset when it rises in value and also when it declines, without having to overcome the psychological barrier of continually choosing to transfer money into your investment account.
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FAQs
Is dollar-cost averaging a good strategy?
Dollar-cost averaging can be a good strategy for steadily building wealth. It can help eliminate timing risk and also potentially reduce your average purchase price.
Does dollar-cost averaging work in bear markets?
Dollar-cost averaging can be an effective strategy to use during bear markets, as you can potentially buy assets when they are lower in value and then experience compelling gains when they rise in price. No one knows when a bear market will end, so it helps you keep investing so that you have more money in the market to potentially benefit from the next bull run.
Can you lose money with dollar-cost averaging?
Yes, you can lose money with dollar-cost averaging if the assets you invest in suffer large enough declines in value. For example, you might dollar-cost average into a stock that eventually goes to zero due to the company's bankruptcy.
Is dollar-cost averaging better than lump sum investing?
Whether dollar-cost averaging is a better approach than lump sum investing depends on your individual situation. If you want to manage timing risk, dollar-cost averaging is the superior strategy. However, lump-sum investing often generates better gains due to providing you with more time in the market.
What's a good amount to invest using dollar-cost averaging?
Any amount that you can afford to invest and helps you move toward your long-term goals is generally a good amount to use for dollar-cost averaging. You may want to seek the input of a financial professional if you are looking to achieve specific investment goals, such as saving enough to retire comfortably.
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