How Dollar-Cost Averaging Works
Dollar-cost averaging helps you balance risk and reward as you invest over time. We break down how it works and who should consider it.
We’ve all heard it – buy low, sell high. Unfortunately, human error and emotion prevent investing from being this simple. For this reason, there are many different approaches to buying and selling securities, such as stocks and mutual funds. One strategy is dollar-cost averaging (DCA), which involves purchasing assets at regular intervals with equal amounts to minimize the risk of buying at the wrong time.
Often, people try and time the market to avoid losing out. However, dollar-cost averaging removes the emotional aspect of this and lessens your risk of buying at the wrong time. In this article, we’ll explain how it works in practice. You’ll also learn the pros and cons of the approach.
What Is Dollar-Cost Averaging?
Dollar-cost averaging refers to buying equal amounts of securities at regular intervals. Doing so lessens the risk of buying and selling at the wrong time. This approach allows you to buy more of an investment when its price is low than when it’s high.
Purchases using this strategy occur regardless of market conditions. This means that even during a bull market you’ll gradually put more funds toward each investment. But doing so also helps reduce the effect of market volatility on your portfolio.
Typically, dollar-cost averaging nets smaller returns than if you invested a lump sum. However, it also reduces your risk of buying in at the wrong time. Often, emotion can dominate an investor’s decisions if they worry about buying at the wrong time. This strategy takes that out of the equation because you’ll be buying shares on a regular schedule with the same amount of money.
Dollar-Cost Averaging in Practice
In practice, dollar-cost averaging is simple. And, as we’ll touch on later in this section, you may already be doing it with a retirement account. Hypothetically, let’s say you have $200 each month to invest. As the market moves up, you’ll buy fewer shares with your money. However, if the market plummets, you’ll be able to obtain more shares with the same amount.
You could also employ this strategy if you have a sizable chunk of cash to invest at a given time. For instance, if you have $5,000 and are interested in a particular stock or fund, you could invest all at once. But you could also incorporate DCA and invest $500 over ten months.
The table below takes the most recent example and assumes you buy into a single stock each month for $500 at varying prices:
Investors often use dollar-cost averaging within retirement accounts, such as 401(k)s and Roth IRAs. This is because people typically make consistent contributions to their accounts, which they then use to buy securities. If one contributes and invests the same amount each month, they’re following the DCA approach.
Benefits and Disadvantages of Dollar-Cost Averaging
Dollar-cost averaging can be an effective method for balancing risk and reward as you invest in a particular stock. It also gives you a more straightforward way to invest, as you’ll follow a regular interval, rather than trying to time the market at a given moment. However, according to Michael Edesess, an adjunct professor and co-author of The 3 Simple Rules of Investing, there isn’t any benefit “in terms of increased investment return.” You may also be subject to excess brokerage fees over time.
Below is a more specific breakdown of the pros and cons of dollar-cost averaging:
- You’ll buy more shares when the price is low than when it’s up. Since you’re spending the same amount of money each time, you’ll buy more shares when the price is low.
- Reduces emotion as you invest. Ever-changing market conditions can make you want to buy or sell at certain times, but DCA eliminates the guesswork.
- Allows you to make smaller contributions over a long period. In this case, there’s a lower barrier to entry with investing while also allowing you to slowly build wealth over time.
- No need to time the market. As mentioned, the guesswork of timing the market is no longer a necessity. All you need to do is make regular contributions with this approach.
- Less chance of large returns. Edesess points out that you risk a “lower expected return on investment because less of the investment is exposed over time to the higher-returning market.”
- Fees. Consistent purchases within a brokerage account could incur fees that cut into your returns.
- Requires discipline. Dollar-cost averaging requires you to conserve the money you have on hand to invest over a long period, which can be difficult if you’re prone to spending or need the money at some point.
Who Should Use It
Any investor looking to sacrifice the possibility of big returns for less risk can use dollar-cost averaging. However, the approach may be handier for some than others. This is especially true for individuals who currently can’t afford to invest a ton or want to avoid risk exposure.
Per Edesess, investors with “no other option than to [buy] piecemeal as opposed to lump-sum” should consider the dollar-cost averaging strategy. This applies to those with limited capital or beginners. It can also refer to people who can’t afford to risk contributing a large sum all at once.
If you’re averse to risk or simply want to maintain a long-term investment strategy, dollar-cost averaging may apply as well. It can also be a way to minimize the stresses and emotions of trying to time the market.
Ultimately, the decision to use dollar-cost averaging is up to you and what you value in investing. If you aren’t sure what route to go, we recommend speaking with a financial advisor. They can sit down with you and discuss your risk tolerance, capital, and goals to find the ideal approach for you.
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Who Should Avoid Using It
While dollar-cost averaging can be beneficial, it can also create a significant opportunity cost. This is especially the case if the market is at a low point. For this reason, some may choose to avoid this strategy.
Individuals who have significant capital on-hand and are confident in their ability to time the market may wish to invest all at once. It may also be appropriate to invest with a lump sum if you aren’t willing to hold on to shares of the stock for the long term. However, you should consult a finance expert before deciding on a strategy.
Frequently Asked Questions
How do I calculate the dollar-cost average?
To calculate the dollar cost average, you’ll need to take the total amount you’ve invested toward a given stock, then divide that number by the total number of shares you were able to buy. For instance, if you spent a total of $10,000 and received 212 shares, your DCA is 47.17.
What does dollar-cost averaging mean?
Dollar-cost averaging is an investment method in which you spend equal amounts regularly to buy shares of a security, such as a stock or mutual fund. It serves as a way to minimize risk due to changing market conditions and limit emotional investing. You’re also able to contribute less regularly, making it easier to buy shares of a stock than if you wanted to contribute a lump sum.
Can you dollar-cost average with ETFs?
You can use dollar-cost averaging to buy various types of securities, including ETFs, mutual funds, and stocks. There may be fees each time you buy shares over time. But it does allow you to avoid trying to time the market, so you don’t lose out.
Is dollar-cost averaging a good idea?
This depends on your values as an investor, as well as the capital you have on hand. If you’re risk-averse or tend to make emotional decisions, you may benefit from dollar-cost-averaging. However, if you’re more experienced or want to see larger returns, buying with a lump sum could be the smart move.
Either way, we suggest you consult with a financial advisor before deciding on how to buy shares. This way, you’ll be able to invest using a strategy that fits your goals.
Does dollar-cost averaging beat the market?
Unfortunately, there isn’t a catch-all answer to this question. According to Edesess, the approach “sometimes ‘works’ (beats the market) and sometimes doesn’t.” And that the result for a given investor seems to depend on “where the market started” for them.
Keep in mind that dollar-cost-averaging isn’t necessarily for beating the market. Rather, it allows you to create a balance between risk and reward as you gradually buy shares. Typically, in the end, you’ll end up buying more shares at a lower price point than at a higher one because you’ll be investing with the same amount of cash each time.
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