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Does stock market volatility make you crazy? Do you go back and forth, deciding if you should invest? It can drive even the calmest person mad! Rather than trying to time the market perfectly, consider dollar-cost averaging.
With the Global Market Cap heading towards $100 Trillion, the stock market is raging hot, and those who try to time the market will pay dearly.
Regardless if you are learning how to invest or if you are a seasoned investor, this article will highlight the overarching themes of dollar-cost averaging, and why it is the best strategy for investors.
This investment strategy diversifies your risk, keeping some of your portfolio liquid for the time being, while using the market’s volatility to your advantage. It is a great long-term strategy for investors that want to learn how to start investing but not let their emotions get in the way.
What Is Dollar-Cost Averaging?
Dollar-cost Averaging (DCA) is an investment strategy that involves investing money over regular intervals rather than all at once. You purchase stocks, bonds, or mutual funds on set dates and in equal amounts.
It works best with volatile investments, such as stocks, as their prices move much more than bonds or other more conservative investments.
Dollar-cost averaging allows you to take advantage of the highs and lows of the stock market. Since no one can predict the market’s positions, you reduce the risk of mistiming the market with Dollar Cost Averaging.
Investing at regular intervals means you will buy stocks at high prices and low prices, but it averages out over the long-term. If you are tired of relying on intuition, regular monitoring, and emotions, then dollar-cost averaging is an investing strategy you need to employ today.
How Does Dollar Cost Averaging Work?
Dollar-cost averaging takes a sum of money and divides it into equal intervals. For example, you received a $5,000 bonus; you could invest it all at once or spread it out and invest $1,000 on the 1st of each month for five months.
If you break up your investments, you will buy more shares when the market is down and fewer shares when it is up.
Do not worry about the purchase price when the stock market is up. If you average the prices over time, you will pay less per share over time than you would if you timed the market ‘perfectly,’ which most cannot do.
When it works, you buy more shares than you would have if you invested the entire amount all at once.
Dollar-cost averaging takes the emotion out of investing.
It ensures you invest at regular intervals, taking advantage of the stock market’s ups and downs. In return, you get a diversified average asset price without relying on emotion, timing, and constant investment research.
>> Not Sure what to invest in? Check out our Motley Fool Review
Does Dollar Cost Averaging Actually Work?
Yes! To this day, dollar cost averaging is one of the most popular investing strategies, and is used by the legend himself, Warren Buffett. This strategy smooths out the market’s volatility.
Rather than investing all of your money at once and hoping for the best, you take advantage of the average stock market prices over time.
It works because it takes two factors out of the equation – fear and emotion. Fear keeps you from investing in the market, and emotion causes rash decisions. Dollar-cost averaging institutes a long-term strategy rather than a short-term focus.
You don’t care what the market does day-to-day. You invest at regular intervals, taking advantage of the market’s highs and lows, and enjoying the average.
Like any investment strategy, though, there’s no guarantee you’ll come out ahead. It depends on how the market responds, which is a risk anyone takes when investing. But, if you invest in index funds, ETFs, or mutual funds, then you can expect to enjoy a healthy return over the long-term.
>> Check out our guide on Index Fund vs. Mutual Fund
An Example of Dollar-Cost Averaging
Here’s a real-life example.
Let’s say you have $10,000 to invest. You received a bonus at work, and the money sits in your boring savings account. You want to invest in ABC stock, which right now trades at $30 per share. If you invested it all right now, you’d buy 333.33 shares.
But what if you invested $2,000 a month for five months, investing on the 1st of each month?
- Month 1: Share price $30, you buy 66.67 shares
- Month 2: Share price $25, you buy 80 shares
- Month 3: Share price, $20, you buy 100 shares
- Month 4: Share price, $25, you buy 80 shares
- Month 5: Share price, $30, you buy 66.67 shares
At the end of 5 months, you bought 393.34 shares or around 60 more shares than if you bought it all at once.
Your average price per share would be $25.51 versus $30 per share if you invested all at once. If you sell high in the future, you will earn more substantial gains. Even if you can’t sell high, you limit your losses with the lower average share price.
What are the Benefits of Dollar-Cost Averaging?
Dollar-cost averaging has its benefits:
- A More Conservative Approach to Investing: One of the most significant investment risks is timing the market. How do you know what it will do? You don’t. With dollar-cost averaging, you pay less attention to the stock’s prices and instead, focus on consistency. With less focus on what the market’s doing, you regularly invest, knowing you’re averaging the stock prices.
- You Buy More Shares: Based on the law of averages; stock prices go down eventually. If you regularly invest over several months, you’ll buy more shares at some point rather than trying to time the market perfectly with your lump sum of money.
- Takes the Emotion Out of Investing: Once you set your investment strategy, that’s it. You don’t look at the stock prices and let your feelings weigh into the decision. Instead, you invest a set amount of money on a set day. This reduces the risk of emotional buying or holding back because of fear.
- Build Up a Sizeable Position: You don’t need a large sum of money all at once. You can build a significant position in the market by investing at regular intervals in smaller amounts.
Downsides of Dollar-Cost Averaging
Every pro has its con, right? Dollar-cost averaging is no exception:
- You Limit Your Returns: Breaking up your investments over time is a conservative approach. Risk and reward go hand-in-hand, so when you reduce your risk, you reduce your profits. Rather than going ‘all in’ when stock prices are at their lowest, you buy a fixed amount in intervals, leaving a portion of your portfolio in cash with no returns.
- Stocks Trend Upwards: Stocks can go either direction, but historically they increase. This may leave you paying higher prices per share over time rather than if you invested it all at once at a lower cost.
>> Related: How to invest in the S&P 500
Dollar-Cost Averaging vs Lump Sum Investing – Which One is Better?
You may wonder, if I have $10,000 now, why would I break up the investments. Isn’t a lump sum investment better? Let’s look at the situation using the above example of a $10,000 investment.
If you invest it all at once at $30 per share, you’d own 333.33 shares. If you sold at the following prices, you’d make:
- Price increase to $40 – you make $3,333
- Price drops to $25 – you lose $1,675
- Price increases to $50 – you make $6,666
Each situation is conceivable. You may make a sizeable profit or limit your losses, but what happens with dollar-cost averaging?
Using our example above, you will buy an average of 393.34 shares if you break up your investments over five months in equal intervals. Using this strategy, you’d make:
- Price increases to $40 – you make $5,733
- Price drops to $25 – you lose $167
- Price increases to $50 – you make $9,667
Dollar-cost average increases your profits and decreases your losses, just by timing your purchases rather than buying in one lump sum. I do not know about you, but I would take the benefits of long-term investing over short-term investing any day of the week.
Who is Dollar Cost Averaging Best for? Should You Use this Investment Strategy?
Investors looking for a lower risk tolerance benefit from dollar-cost averaging. Rather than trying to time the market and/or regulate your emotions to make profitable decisions, you automate your investments.
Plain and simple, dollar-cost averaging is best for those with a long-term investment strategy. You take advantage of the stock prices averaging over time, rather than capitalizing on one stock price.
You will buy at higher and lower prices, but take advantage of the average stock price, hopefully buying more shares over time. If you are not sure what stocks to buy, then give Morningstar a try. They are the go-to source for market research.
Should you use dollar-cost averaging? It depends on your situation. Do you have a lump sum you can break up? Are you okay with some of your portfolio sitting in ‘cash’ and earning little to no interest?
Do you prefer to take the emotion out of investing? If you are in it for the long-term, then DCA may benefit you.
>> Next Steps: Best Investing Apps
How to Start Dollar Cost Averaging
DCA is one of the most straightforward investing strategies to employ in your portfolio. If you have a Roth IRA or an Employee Sponsored Investment Account (401k) which you contribute to monthly, then you are already taking advantage of this popular investment strategy.
Fortunately, most brokerage accounts make it easy for you to start dollar-cost averaging. However, you will have to do some research on your end and pick a stock, index fund, or mutual fund to invest in.
After you decide what to purchase, you can set up automatic purchases through your brokerage account. If your brokerage account does not support automatic investments (doubt this happens), then set a monthly reminder and login to your account and make the purchases yourself.
This should only take about 5 minutes, and as you can see, dollar cost averaging offers great benefits.
If you do not have a broker, then make sure to check out our expert list of the best online stock brokers.
Wrapping Up: Dollar Cost Averaging
If you are an emotional investor or you hold back because you think something better is coming, consider dollar cost averaging. You will invest in more shares and minimize your losses.
If you prefer a more analytical approach to investing, though, buying when you know the time is right rather than jumping in because it’s a certain date, you may want to stick to your traditional investment methods.
But remember, the more upfront investment research you do, the better.
Either way, make sure you are in it for the long haul.
Investing should not be a short-term strategy. Ride out the storms, take advantage of the market’s highs and lows, and enjoy a better return when you avoid emotional trading decisions.
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