How to invest using dollar-cost averaging
- Dollar-cost averaging is an investment strategy that can help you pay less for investments and better manage risk.
- Instead of investing in a security all at once, dollar-cost averaging is the process of investing a fixed dollar amount at regular intervals over a long period of time.
- Dollar-cost averaging may underperform lump-sum investing in certain cases.
Investing is all about managing risk and reward. The
Instead of trying to time the market, there's an alternative strategy that can be beneficial for investors at all levels: dollar-cost averaging.
What is dollar-cost averaging?
Dollar-cost averaging is the process of spreading out an investment purchase by investing equal dollar amounts at regular intervals. Instead of buying a stock or fund all at once, dollar-cost averaging involves portioning the purchase out over time.
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 during the dips and buy less when prices are high - basically leveling things out and reducing risk amongst 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 LaFleur, lead planner and CFP® at LearnLux.
Dollar-cost averaging vs. market timing
Dollar-cost averaging is a way for investors to continue to put money into the market despite market conditions. Through dollar-cost averaging, investors put 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 volatility.
|Dollar-cost averaging||Market timing|
|Means investing set amounts at regular intervals Can remove emotion from investing Focus is on consistency and disregards market performance||May delay investments based on market conditions May lead to regret or procrastination Focus is on adding money at the right time, and can lead to higher returns - or losses|
Quick tip: If you want to get started with dollar-cost averaging, set a budget for how much you want to invest as well as the interval to set the frequency. For example, you could invest $250 each month.
How dollar-cost averaging works
Dollar-cost averaging has two components:
1. The fixed amount you invest
2. The regular interval 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).
Dollar-cost averaging works because it's about consistently funding your investments and putting money into the market, rather than holding back and attempting to time the market. "It's 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.
Examples of dollar-cost averaging
First scenario: Let's say you want to spread out $300 and invest $100 over three months. If you want to invest in a security that's trading at $20 per share, you'd be able to purchase five shares in one month for $100. 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 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|
In this example, even with price fluctuations over the three months, at $300 invested with 17 shares, your average cost per share is $17.6 ($300 ÷ 17 = $17.6).
If you were to sell in month four at a $20 share price (the same price as month 1), you'd sell your 17 shares for $340, with a profit of $40. If you were to sell in month 4 at a $40 share price, you'd sell your 17 shares for $680, making a profit of $380.
17 shares (total shares) X $20 (share price) = $340 (sell value) - $300 (total investment) = $40 (profit)
17 shares (total shares) X $40 (share price) = $680 (sell value) - $300 (total investment) = $380 (profit)
Second scenario: If you choose to go with the lump-sum investing strategy and chose to invest $300 in that first month at $20 per share, you'd have 15 shares. That's two fewer shares you'd have compared to consistently putting money into the market. In this example, dollar-cost averaging would beat a one-time lump sum investment. On top of that, your average cost per share is a few dollars lower as well ($17.6 vs. $20).
In this case, if you were to sell in the month four at $20 share price, you'd sell your 15 shares for $300, effectively breaking even and not making a profit. If you were to sell in month 4 at a $40 share price, you'd sell your 15 shares for $600, making a profit of $300.
15 shares (total shares) X $20 (share price) = $300 (sell value) - $300 (total investment) = $0 (no profit)
15 shares (total shares) X $40 (share price) = $600 (sell value) - $300 (total investment) = $300 (profit)
|Amount invested||Strategy||Average cost per share||Pros||Cons|
|$300||Dollar-cost averaging||$17.6||Lower average price by share More sustainable||May lead to fewer returns|
|$300||Lump-sum investing||$20||Higher amount for longer period of time, can lead to higher returns||Cost per share may be higher Must have more saved to invest a lump sum|
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 in spreading your risk and lowering the average amount you pay for shares. But there's a strong case for lump-sum investing, which exposes you sooner in the market and has been found to be more beneficial as a strategy.
In a study done by Northwestern Mutual, it 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 fewer returns as well. 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.
Advantages of dollar-cost averaging
Dollar-cost averaging helps investors remain consistent in their quest to build wealth and can combat fear. When investors are fearful, it can lead to poor decision-making. So staying the course can help over the long-term and remove emotions from your 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.
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, using dollar-cost averaging, you can invest a smaller amount in regular intervals to build wealth over time.
Dollar-cost averaging is a good strategy for investors who may not have tons of cash to invest right away as well as for people who don't want to concern themselves with the ups and downs of the market.
If your risk tolerance is low and you get nervous about shifts in the market, this could also be a good strategy to help you stay the course. Otherwise, you might sell in a panic and potentially lose out on important gains in the long run.
If you have a large sum of cash to invest or you're investing for a specific goal over the short term, lump sum investing may be a good fit.
Disadvantages of dollar-cost averaging
As noted above, dollar-cost averaging may offer less in the way of returns than lump-sum investing in some instances. Additionally, when prices are high you may get less bang for your buck.
"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 brokerage fees which could take a chunk out of your nest egg. Be sure to research fees and costs as part of your investment planning.
Quick tip: It's important to understand your risk tolerance to know which investment strategy is best for you. If big shifts make you nervous, dollar-cost averaging may be a good option to continue investing despite market volatility.
The financial takeaway
Investing can be an emotional process, no matter how much experience you have. Dollar-cost averaging is one investment strategy that can help minimize the anxiety around investing as you continue to put money in the market consistently, regardless if things are booming or tanking.
On top of that, it's a good option for investors who are starting out with a little bit of money to get started with investing. Many people may not have a lump sum to get started investing, but you may be able to throw an extra $100 or more toward investing each month.
Just be aware of brokerage fees and your personal risk tolerance to help guide your investment decisions. As always, you can talk to a financial professional to find the best option for you.What is compound annual growth rate? FINRA: The organization that regulates broker-dealers and protects investors How stock quotes can better inform your investing decisions A comprehensive guide to investing in stocks for beginners
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