Investing isn’t something you immediately know everything about. If you are just getting started in the stock market, you may still be learning important concepts. And you will learn more details about how to invest money as you continue investing and educate yourself.
But one concept you may already be putting into practice without even knowing it is dollar-cost averaging.
Chances are you’re dollar-cost averaging if you make automatic contributions at regular intervals to a workplace retirement plan, such as a 401(k), an IRA (individual retirement account), or any other investment account. But even if you’re already doing it, you should understand how it works.
Here’s what you need to know about this investing strategy to decide whether it’s a good fit for your personal finance situation and goals.
What is dollar-cost averaging?
Dollar-cost averaging is the practice of investing a fixed amount of money on a recurring basis, such as biweekly or once per month, over a long period of time. Easy-to-understand examples of the dollar-cost averaging strategy in action are investing 5% of your salary every paycheck in a 401(k) or $200 every two weeks to an Individual Retirement Account (IRA).
If you invest only once per year, you may end up investing at the market’s high. This could result in lower returns in the future. Market volatility means the prices of investments can swing drastically over short periods. It can seem trickier than usual to figure out smart money moves to make in a volatile market.
Dollar-cost averaging takes away these potential downsides. It does this by spreading out your investment over a number of purchases. Because you invest using a particular schedule without fail, you buy the investment when its market price is up, down, and everywhere in between.
Historically, the stock market’s long-term trend results in rising prices overall. As long as you stay invested in a diversified portfolio and this trend holds, your investment may be worth more in the future than when you buy it, regardless of this year’s highs or lows. Even so, always remember that the past performance of an investment isn’t a guarantee of future results.
Dollar-cost averaging is easier than ever thanks to technology and investment apps. Once you have an investment account open, look for an option to schedule automatic investment purchases. You should be able to do this in most account types including 401(k)s, IRAs, and taxable brokerage accounts.
Most investment types, such as mutual funds, exchange-traded funds, and stocks, are compatible with dollar-cost averaging. Brokerage firms that allow fractional share investments, an option where you can buy less than a full share of an asset, make this strategy even more accessible. Without fractional shares, you’d have to save up money to buy a single share of a large company with a $1,000 share price. Combining fractional share purchases with dollar-cost averaging allows you to invest a fixed dollar amount every period and get your money working for you immediately.
When scheduling these automatic investments, just make sure they do not exceed any annual contribution limits. For instance, someone making $200,000 per year who decides to put 20% of their salary in a 401(k) would end up exceeding the $19,500 annual 401(k) contribution limit. But this points to yet another benefit of dollar-cost averaging. You can simply divide your annual limit into a certain amount of payments and use that number when you schedule your automatic contributions.
How dollar-cost averaging works
Dollar-cost averaging may sound complicated to put into practice, but it’s really not. Although you invest a particular amount each period, the number of shares your money buys varies. The number of shares you end up with will depend on its purchase price at the time. Thankfully, your brokerage does the math for you. You just have to regularly invest a set amount of money.
Here’s an example of the dollar-cost averaging strategy in action to show you how this works:
Joe decides to invest $250 on the first day of each month in a total stock market index fund. On the first investment date in January, the share price of that index fund is $25. The share price fluctuates throughout the year, but Joe continues investing $250 on the first of each month.
In months where the price increases, he buys fewer shares. In months where the price decreases, he buys more shares. In all months, the amount he invests stays the same. The below chart shows how these changes impact the number of shares Joe buys throughout the year.
|Month||Share price||Investment||Shares purchased||Total shares owned||Total value of shares|
The results may be surprising to a new investor. In this instance, Joe ended up earning $846 above what he had invested throughout the year without spending hours analyzing individual stocks or trying to time the market.
The advantages of dollar-cost averaging
Starts building a long-term habit
A recent FinanceBuzz survey found that almost 62% of Americans think you need at least $1,000 to begin investing. But the truth is you may not even need $10 to start, as dollar-cost averaging allows you to invest with small amounts.
Many investing apps allow you to schedule recurring investments. They can be as small as a few dollars with no account minimum requirements in many cases. This starts the habit of investing. Then, you can increase these amounts as you’re able. By investing more over time, you can grow your investment holdings even faster.
Helps you buy more shares when investment prices decrease
In a declining market, dollar-cost averaging allows you to buy more shares. This happens because you invest the same amount each period regardless of investment prices. So you get a great deal on your purchases. When the stock prices increase in the future, it results in a larger value for your investment account because you own more.
Avoids the complexities of timing the market
Trying to time the market may seem smart. After all, buying low and selling high could make you a handsome profit. Unfortunately, it’s much easier than it sounds. You have to buy at the low, sell at the top, and reinvest at the next bottom to perfectly pull this off.
Even if you happen to time one of these events, chances are you’ll miss the other two. People who aren’t invested on the best days in the markets, which can happen right after some of the worst days, often receive much lower returns than those who stay invested through the good and the bad.
Removes the risk of emotional investing
Figuring out exactly when to invest can be tricky. During market downturns, fear can make you avoid investing. No one wants to see their investment balance drop. At the same time, investing in a rising economy may seem like you’re putting money in at the top of the market. This could be bad when you consider the next bear market could be right around the corner.
Dollar-cost averaging removes emotion from your investment decisions. It lets you continue building your investment balances through good and bad times. You simply buy on a set schedule.
How to use dollar-cost averaging
If you’re convinced dollar-cost averaging is the right investing strategy for you, it’s easy to get started. First, determine how often you want to invest. If you’re investing in your workplace retirement plan, you typically invest with each paycheck.
Next, determine how much you want to invest. You may decide to set a yearly investing goal. Divide the goal by the number of investments over the year. For instance, someone who wants to invest $5,200 over the next year on a biweekly schedule would divide $5,200 by 26. This results in a regular investment amount of $200.
Others may find it easier to invest a set amount per month. Most people don’t budget on an annual basis, and you may have a better picture of your monthly income and expenses. By investing what you can afford in your normal monthly budget, you may be more likely to keep investing.
After you decide how often and how much to invest, it’s time to pick what you want to invest in. In a 401(k), you can often set your contributions to go to whichever investments your plan offers. For non-workplace retirement plans, pick a brokerage account that offers the investment choices you prefer. These could include stocks, ETFs, mutual funds, or even cryptocurrency.
Finally, set up a recurring investment schedule. With a workplace retirement plan, this is normally taken care of for you, based on your pay periods. For brokerage accounts, look for a recurring investment or scheduled investing option within your account. If you can’t find one, call the brokerage and ask how to set one up.
Many of the popular investing apps offer automatic investing features. Several also include an option to buy fractional shares with this service. Combining these two concepts allows you to invest consistently without having to remember to make a purchase each period.
Apps such as M1 Finance, Robinhood, and Betterment all offer these options. On each investment date, a company withdraws money from the bank account that you designated as your funding account. It then uses the money to buy as much of your predetermined investments as possible.
FAQs about dollar-cost averaging
Is dollar-cost averaging a good idea?
Each person must decide whether the dollar-cost averaging strategy is a good fit for their needs. It can facilitate you building a healthy investing habit. This may set you up for future financial success even if you don’t have a large amount of money to make a lump-sum investment. It also helps you avoid market timing when you’re investing for the long-term because the process is automated. So depending on the type of investor you are and your ideal timeline for your investments, you may find dollar-cost averaging to be a good idea.
What are the disadvantages of dollar-cost averaging?
Dollar-cost averaging isn’t a good fit for everyone. In particular, those who have a large lump sum to invest may miss out on potential returns. If you dollar-cost average your money out over a period of time when your investment is rising in price, you’d be worse off than investing a lump sum upfront. Unfortunately, it’s impossible to predict the future so it’s hard to know when this strategy may pose this disadvantage.
Is dollar-cost averaging better in a bear market?
Dollar-cost averaging can help you purchase more shares of the same investment in a bear market, which is generally considered to be when the market is 20% or more below a recent peak. If the investment keeps declining, you can buy more shares with each investment. That said, the investment’s price needs to eventually turn around and increase over the long term for this strategy to turn out for the best.
Dollar-cost averaging can help you create a healthy investing habit, especially if you set it up using automated investing tools such as the best investing apps. Although this investment strategy isn’t perfect in all cases, the benefits often outweigh the downsides for those getting started on their investing journey.
Consistent investing on a regular basis allows you to buy when investment prices are high, low, and everywhere in between. If the markets continue providing positive investment returns over long periods, dollar-cost averaging could help you become a millionaire by the time you retire. The key is staying invested and sticking to your plan.