Dollar-Cost Averaging: An Investment Strategy to Avoid "Timing the Market"
Investing can be complicated, especially for someone getting started.
You have to decide how much risk you’re willing to take and what to invest in that matches that risk.
You also have to figure out what brokerage to use to make your investments, how much to invest and when to invest.
All of these factors combined are an important part of an investment plan.
Thankfully, there’s an investing strategy that can make one of those decisions much easier.
Dollar-cost averaging can help you automate your investing. This takes care of the timing part of your investing decisions.
Here’s what you need to know about dollar-cost averaging including the pros and cons behind this method.
What Is Dollar-Cost Averaging?
Dollar-cost averaging is a strategy where you invest a fixed amount of money on a schedule.
For instance, you could choose to invest $100 per month, $50 per paycheck or $2,000 per quarter.
The key is:
Invest the same amount of money every interval of time without fail.
The price of the investments you buy may rise or fall over time, but you buy the same dollar amount each time period.
This means you buy more shares when the purchase price is lower and fewer shares when the purchase price is higher.
Dollar-cost averaging works best with brokerage firms that offer commission-free mutual fund trades or those that allow buying fractional shares of your investment.
These options allow you to invest the entire amount you want to dollar cost average without having any money left over.
To some, dollar-cost averaging may sound complicated. In reality, the most complicated part is setting up your plan.
Once you have your plan, you can often automate it. Then, you only have to check in to make sure it’s working as intended and to take care of other investing tasks.
You might already be dollar-cost averaging and not even know it. If you invest in your retirement plan at work, that’s dollar-cost averaging.
Most retirement plans allow you to decide how much of your income you want to invest each paycheck.
Some plans allow you to choose a percentage while others allow you to choose a set dollar amount. Either way, you’re investing a predetermined amount at regular intervals with a workplace retirement plan.
Let’s say you invest 10% of your $52,000 annual salary in your workplace retirement plan. You get paid weekly and your gross pay is $1,000 per week. In this case, you’d be investing $100 per week.
An example of dollar-cost averaging
|Week||Share price||# of shares purchased||Total shares owned||Value of holdings|
So, you purchased 37.5 shares at an average share price of $10.67.
Benefits of Dollar-Cost Averaging
Dollar-cost averaging has many benefits that can help the average investor get started and to continue investing.
Can help reduce worry
When you have to actively decide when to buy (or sell) investments, it can become stressful. You might be looking for the perfect time to get the best price possible.
Dollar-cost averaging eliminates the stress of timing your purchases.
Unfortunately, waiting for the perfect time to invest may lead to you not investing at all. If you’re waiting for a dip and the dip never comes, you may never start investing.
When you finally do decide to invest, prices may be higher than when you first started looking for the perfect timing.
Instead of trying to save one or two percent of the investment’s cost by timing the market, focus on how much you can invest each time period.
With dollar-cost averaging, you’ll end up buying at some high points and some low points. Over time, the highs and lows will likely even out. The most important factor is you’re invested.
Avoid the investing newscycle
If you dollar cost average, you probably won’t feel the need to keep up with the markets as much.
This can be a huge benefit because you won’t be exposed to the headlines investing sites come up with to increase readership that can incite worry or panic.
According to the investing sites, there is always some big reason or move in the investment world that you should be paying attention to.
You should focus on investing for the long-term, not the day to day swings talked about on these sites.
Keeps a long-term outlook
When you’re investing for retirement, chances are your final goal is decades away.
Whether you save one or two percent on a particular purchase today will have almost no meaningful impact on your future nest egg size in most cases.
Getting invested in the market earlier gives you more time for you to earn and compound your returns.
Simple, automated process
Most brokerage firms allow you to automate your dollar-cost averaging investments, especially if you’re buying mutual funds or the brokerage allows fractional share ownership.
Simply tell the brokerage firm how much you want to invest and how often you want to invest.
The brokerage firm will automatically take the money out of your bank account or paycheck and invest it on your behalf.
You don’t have to worry about anything other than increasing the automatic investment amounts in the future as your ability to invest more grows.
Automating your dollar-cost averaging helps you make sure you never miss an investment. It also makes it a habit.
After a few automatic investments, you won’t even likely miss the money anymore because it will seem normal.
Downsides of Dollar-Cost Averaging
While dollar-cost averaging definitely has benefits, it isn’t a one-stop solution to all investing problems.
Doesn’t solve all problems
Dollar-cost averaging only solves the problem with the timing of your investments.
In order to have a good investment plan, you still need to take care of other tasks beyond deciding how much and when to invest.
For instance, you need to figure out what you want to invest in and how you want to allocate your investments as a whole.
After deciding on your asset allocation, you also want to make sure you have a diverse set of investments. That way, if one investment performs horribly, other investments may make up for it.
Over time, your investments will grow by different amounts. You’ll need to occasionally rebalance your portfolio to maintain your ideal asset allocation.
You do this by selling investments that have become too large of a part of your portfolio and buying investments that are underrepresented.
These are all major parts of investing that dollar-cost averaging won’t be able to help with.
Could miss out on returns
In some cases, you could miss out on returns with dollar-cost averaging.
Let’s say you get a bonus at the beginning of each year worth $12,000 after taxes. If you invest that $12,000 using dollar-cost averaging over the next 12 months, you’d invest $1,000 per month.
Historically, the stock market grows in value over long periods. By waiting to invest rather than making a $12,000 lump sum investment at the beginning of the year, you could very well miss out on some of that growth.
At the same time, the stock market could decline in the short-term. In this case, dollar-cost averaging would work out better in the short-term.
No one can predict the future.
Historically, the market goes up.
So, the earlier you invest your money earmarked for long-term investments, the more returns you typically stand to gain.
Could incur more fees
Another potential downside of dollar-cost averaging is increased fees.
While you can dollar cost average for free with many brokerages and types of investments, not all investments are free to trade.
For instance, you may choose to invest in a particular investment that requires paying a trading fee to buy and sell the investment. In these cases, you’ll have to pay the fee every time you invest.
If you dollar cost average weekly, you’ll have to pay that fee 52 times a year. If you only dollar cost average monthly, the fee will only be paid 12 times per year. The lowest possible fee would be investing only once per year.
You should look to find a brokerage firm and investments that charge minimal fees. It is very possible to dollar cost average without paying any transaction fees with popular index funds.
The Key Is Getting Started
The concept of dollar-cost averaging eliminates one of the confusing aspects of investing: when to buy your investments.
You may already be dollar-cost averaging and not even know it thanks to your workplace retirement plan.
That said, this strategy isn’t a perfect solution for everyone and every situation.
Even so, the key to investing, in the beginning, is getting started. Over time, you’ll learn from any mistakes you make and refine your investing method.
The best part:
Dollar-cost averaging can help you avoid the mistake of timing the market if you automate your investments and it keeps you away from reading stock market news.
You may continue to dollar cost average your whole life or you may find a different solution that works better for you.
Whatever you decide to do, get started investing today so you can start building wealth for your future.