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Updated on Thursday, April 1, 2021
Dollar-cost averaging is a strategy for investing in which you invest about the same amount at regular intervals regardless of how the market is performing. Rather than putting a lot of money in at one time, with dollar-cost averaging you add regular amounts of money into your investment account on a consistent basis.
This strategy lessens your chances of buying when the price per share is too high, lowering your investment’s purchase price. We dive into how dollar-cost averaging works and when it may make sense for your investments.
What is dollar-cost averaging
Dollar-cost averaging, or DCA, is investing regularly no matter what’s happening in the market. Doing so spreads out the price you pay for investments, by making purchases at regular intervals over the course of weeks or months.
You might already be doing DCA and you don’t know it. If you have a work-sponsored 401(k) through your employer, you’re making regular, fixed contributions at a set time — usually every paycheck.
How does dollar-cost averaging work?
With lump-sum investing, you take a chunk of money and put it into the stock market. Dollar-cost averaging splits up the cash over a set amount of time and invests the same amount at the same time, regardless of share price.
Say you have $500 to invest. With DCA, you will buy $100 worth of shares (and typically the same investment) every month for five months. Here’s how that looks:
|Dollar-Cost Averaging Example|
|Timing||Amount invested||Share price||Total shares purchased|
|Total invested: $500||Total shares owned: 165|
Since you’re investing the same amount each month, you’re buying fewer shares when the cost is high and more shares when the cost is low. Thus, dollar-cost averaging can lower the average cost per share that you will pay (for the above, that’s about $3.03 a share) when compared with lump-sum investing.
Dollar-cost averaging vs. lump-sum investing: Which is better?
Even the most experienced investors will tell you that you can’t time the stock market, or buy a security at a low cost and expect to sell it at a high price point based on expert predictions. While this might work for a day trader, most folks don’t have the same time, energy or experience to do this. This means the best investment strategy might differ based on the type of investor you are.
Dollar-cost averaging is a great strategy for long-term investing. It minimizes your overall risk, removes emotion and continuously keeps you investing. However, it might not be best if you’re looking for a quick cash out.
Lump-sum investing, on the other hand, gives you a chance to invest in stocks at a low price point, which is good if you have a solid working knowledge of the stock market. But not everyone is that lucky. People who are adopting a lump-sum investing approach might put off investing until they’ve saved a certain amount. This means lump-sum investors are missing out on potential earnings every day they aren’t investing.
When prices aren’t fluctuating very much, DCA and lump-sum investing will usually produce similar returns. But if you look at the example above, even $1 to $2 per share makes a difference. Imagine if you took your $500 and bought all your shares at once, at $5 each. You’d have 100 shares, not 165. While you could get lucky and buy them at $2 each, that’s not necessarily guaranteed.
But not everyone has the cash on hand to invest when prices are low. On the flipside, you could miss out on even higher potential rewards with DCA. In a rising market, lump-sum investing would net you a greater return. In fact, a 2012 study from the Vanguard Group found that lump-sum investing outperforms dollar-cost averaging two-thirds of the time. Still, if you’re concerned with minimizing risk and regret, DCA might be a better alternative.
Dollar-cost averaging pros and cons
- Steady investments: For some people, investment contributions are made after a long list of other needs are met, like paying your bills and getting out of debt. With DCA, you add money to your investments just like any other bill. By actively making your investments a priority, this creates good investing habits for people who wouldn’t normally make regular contributions.
- Minimizes risks: Investing the same amount of money every month means you don’t have to constantly watch the market to see when to jump in. This strategy lets you add money to your investment account without worrying about buying when the price per share is at the high.
- Removes emotion: Even though investing is full of emotion, it’s still a business transaction. When buying, DCA removes the burden of trying to figure out when prices are low, and it can help you to fight the urge to sell when prices drop. In fact, you don’t have to watch the market much, if at all, and can stay the course and focus on other tasks at hand.
- Could hurt overall returns: Even though you’re buying less when the share price is up, you’re not putting more money in when the share price is down. You’re losing out on not maximizing profits by establishing a lower cost basis for investments.
- Trading and brokerage fees creep up: If you’re constantly buying and selling stocks, you might get hit with trading fees, depending on which brokerage you use.
- Doesn’t work for all investments: If you have long-term plans, like a 401(k) or a similar account, DCA might be great for you. But if you’re a more active trader and you want to sell within the next few months or years, you may want to be a little bit more aggressive with your investment strategy, especially stocks and similar securities.
How to start investing using dollar-cost averaging
Step 1: Decide how much you can invest and at what frequency
If you’ve received a bonus, raise or inheritance, you can set aside a certain amount of money each month to go towards your investments. Put the extra cash in a high-yield savings account and set up a scheduled payment to auto-deduct from that account. For some people, contributing every paycheck might be best, which is often twice a month.
Auto-deductions let you set the amount and date to be consistent every month. Automation removes the emotion tied to contributing to your investments. You’re literally setting it and forgetting it.
Step 2: Determine where you want to invest
You can set up contributions through your work-sponsored 401(k) or similar account, which your employer can help you manage. You can also open an IRA or taxable account with a brokerage or robo-advisor.
Some accounts require a minimum amount to get started, so if you only have a little, look for accounts that have a $0 account minimum. Use your risk level — risky or conservative — to determine which investments are best for you, like mutual funds, ETFs or individual stocks and bonds.
Step 3: Keep investing at regular intervals
After you’ve opened your account, link your bank and set up auto-deductions. You can always adjust to your needs, like if you’ve recently received a raise and want to start contributing more. Or if necessary, you can pause contributions until you’re financially prepared to start investing again. The best option is to stay as regular as possible to make investing a habit.
If you have the opportunity to add more money, like if you got a work bonus or a new side hustle, that’s great. But you don’t have to feel obligated to add more than you need.