Dollar cost averaging is a simple strategy that can increase your investment returns and reduce your risk. With this method, an investor purchases equal dollar amounts of an investment regularly over time instead of putting a lump sum of money into the market at once.
Using this strategy minimizes the chance of buying at a high point and can help lower an investmentâ€™s average purchase price, increasing an investorâ€™s overall return. Hereâ€™s how dollar cost averaging works and nine things you need to know about it.
Perhaps the biggest advantage of dollar cost averaging is the fact that it puts the stock marketâ€™s natural fluctuations to work for you.
If you buy in a large lump sum and mistime the market, it can be a long climb out of the hole. But by spreading out your purchases over time, you could avoid putting all your cash in at the top of the market and likely will buy some shares at a lower price. This can reduce your risk and help you buy at an average value over the period of your purchases.
If you commit to dollar cost averaging â€” buying regularly regardless of the marketâ€™s performance â€” youâ€™ll avoid a temptation that hurts many investors. Some become fearful when the market drops and donâ€™t buy, but when the market rises, they start buying again.
In the end, they pay a higher price than they ought to. Rather than trying to make decisions as the market fluctuates, commit to a regular schedule of purchases and take the emotion out of it.
Dollar cost averaging often helps you achieve a lower price for your position. While the strategy really shines when the marketâ€™s falling, it can help lower your risk in all markets.
For example, letâ€™s say you buy 100 shares of a $10 stock in a lump sum for $1,000. Your cost basis is $10. If the stock falls to $5, youâ€™re suddenly down $500. Even if the stock later recovers to $7.50, youâ€™re still down $250.
With dollar cost averaging, you take advantage of this drop. Letâ€™s say you split your buys into two $500 chunks. At $10 per share, you spend $500 and receive 50 shares. Then at $5 per share, you spend another $500 and receive 100 shares. Now you own 150 shares with a cost basis of $6.67 per share. When the stock recovers to $7.50, your investment is now worth $1,125 and youâ€™ve made a profit of $125, even though the stock has only partially recovered.
In a flat market, a lump-sum approach and dollar cost averaging produce nearly the same profit, but the investor had to have more money in the market and so took more risk. Meanwhile, the investor using dollar cost averaging had less money in the market, took less risk and had the potential to take advantage if stocks fell.
Even in a rising market, with less money in the market at one time, dollar cost averaging reduces your risk, though it will cost gains that you could have had with a lump-sum approach.
Dollar cost averaging forces you to think long term. When youâ€™re buying a stock, you want it to be as cheap as possible, and that means hoping for it to go lower before it finally goes higher.
At lower prices, youâ€™ll buy more shares, so when the stock does rise, your gains will be even greater. But you have to think long term and be willing to stomach short-term losses and consider them great buying opportunities.
Dollar cost averaging can run up trading costs if you donâ€™t carefully manage how often youâ€™re buying and how many securities youâ€™re using this strategy for.
Purchasing just one or two stocks or funds? Youâ€™re probably all right. But pay attention to how often youâ€™re buying. For most people, buying weekly is too much; if you purchase too often, you wonâ€™t give the market enough time to move. Biweekly or monthly is a better option for most.
Plus, if you trade too often, fees will eat up money that could be put into stocks. Of course, if youâ€™re using a free trading app, such as Robinhood, those extra trades wonâ€™t cost you anyway.
Dollar costs averaging generally makes the most sense for volatile assets because it takes advantage of and protects against price fluctuation. That means the strategy is ideal for stocks, stock-based exchange-traded funds and mutual funds.
Itâ€™s likely not a great fit for relatively stable securities, such as bonds or high-yield savings accounts, because they donâ€™t move around as much. These stable assets will move, of course, but over a much longer time frame, so mistiming a purchase is less costly.
Dollar cost averaging is a great strategy for individuals and less sophisticated investors, but in a rapidly rising market, this approach is going to cost you. In a rising market, a lump-sum purchase would have worked out better. But that requires timing the market correctly, a risky approach that savvy investors usually avoid. And no one â€” not even the top professionals â€” knows which direction the market is headed.
Because of that, itâ€™s usually best to limit your risk, avoid timing the market and take advantage of the marketâ€™s drops.
If your idea of a good time is watching the calendar for the right day of the month to buy stock, then make your investments manually. For the rest of us, find a brokerage thatâ€™s able to automate the process so you can spend more time on the things you enjoy.
You can set up your account to buy on a preset schedule, and all youâ€™ll have to do is make sure the money is available. Even easier, many brokerages can pull the money right from your bank account.
This automatic approach is great because it keeps your emotions out of the investing process. Instead, set it and forget it.
Do you contribute regularly to a 401(k) program and invest your contribution in the market? Then youâ€™re already using dollar cost averaging. Youâ€™re using the power of automatic investing to continue buying even when the market dips and keeping your emotions out of the decision-making process. Itâ€™s the way to be pleasantly surprised when you check your account balance.
Dollar cost averaging doesnâ€™t always lead to maximum gains, but it works well in many situations and can help protect your portfolio from bad outcomes. And because itâ€™s a formulaic purchasing plan, itâ€™s even better for beginning and intermediate investors who donâ€™t want to spend their time thinking about how and when to invest.
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