What Is Dollar-Cost Averaging?

Volatility is a natural part of investing, and every investor must contend with inevitable price fluctuations. However, investors may struggle to invest in bear markets and market downturns due to risk aversion. One of the best ways to approach investing without getting worried about volatility is through dollar-cost averaging (DCA).

What is dollar-cost averaging?

Dollar-cost averaging involves spreading your investment over time and at regular intervals, regardless of which direction the market or a particular investment is going in. When you employ this strategy, you invest equal installments of money into the market without focusing on the price of the stock, security or fund or the overall volatility of the market. This approach eliminates the risk of timing the market and can encourage a healthier approach to investment management.

How dollar-cost averaging works

With dollar-cost averaging, you decide which securities you want to purchase and the amount you wish to invest each month, biweekly or at a different chosen interval. The goal isn’t to time the market and invest when prices are high or low but to keep your investment steady and strengthen your position over time.

If you have a 401(k) account, you're already practicing DCA by taking money from each paycheck throughout the year and investing it in the market on a regular, fixed schedule, regardless of market conditions.

You can also apply the DCA strategy as an alternative to investing a lump sum of money. For example, instead of investing $5,000 at once, you’d split it into five parts and invest $1,000 each month for five months.

Benefits of dollar-cost averaging

Trying to time the market is a risky endeavor. By using the dollar-cost averaging approach, investors can remove their hesitations about prices or stock market volatility from the act of making consistent investments. Adopting this approach also helps investors take a long-term view of the market: Instead of considering short-term ups and downs, investors contribute money to their accounts with a focus on growth over time.

As of Dec. 30, 2022, the S&P 500 stood at -19.44% for the year. DCA works because its focus is consistently funding your investments and putting money into the market instead of accumulating cash and attempting to time the market.

Consider these additional benefits of dollar-cost averaging.

DCA lowers the average amount you spend on investments

You can make a volatile market more likely to work to your benefit by adopting DCA, especially if you might otherwise be tempted to buy shares when the market is high and hesitate when the stock market sinks. This investment strategy spreads out your investment entry points to potentially achieve a lower average cost base. As a result, you’ll buy more shares of an investment when the share price is low and fewer shares when the share price is high. This can result in a lower average price per share over time and limit your losses if the market declines.

The following examples take a look at a few different scenarios. Example A shows us what would happen if the market never changed. You invest $100/month at $20/share for five months and end up with $500 worth of shares at a constant cost of $20/share.

Example A: How flat stock prices impact a DCA strategy

Example B shows us what would happen if you invested a lump sum when the market is strong. Again, we end up with $500 worth of shares, only this time we overpaid for them, as the average cost of these shares over 5 months was $13/share and we paid $20/share in January.

Example C illustrates the power of dollar-cost averaging. By spreading out $500 over the course of five months in a fluctuating market, we end up with a total of $1000 worth of shares at an average cost of $13/share.

DCA builds investment discipline

Like a regular 401(k) deduction from your paycheck, dollar-cost averaging forces you to think long term, invest consistently and with discipline. You don't have to keep your eye on different investments or market volatility. Just figure out how much money you want to invest regularly and commit to that schedule.

It takes the emotion out of investing

Dollar-cost averaging can help take the emotion out of investing. It compels you to continue investing the same amount regardless of the market's fluctuations. Also, investors who use it can disregard news and information hype from various media about the market's short-term performance and direction; this helps you resist the temptation to time the market. Since you're investing smaller sums of money over time, it’s much easier to stomach a poorly timed investment. You'll also be less likely to cling to a single price anchor, making it easier to buy and sell according to a predetermined plan.

Potential downsides of dollar-cost averaging

Like any other investment strategy, dollar-cost averaging has its drawbacks, including:

• Missing out on potentially higher returns. If the price of an investment rises over time, you’ll end up buying fewer shares than if you’d made a lump sum investment at the outset. Generally, DCA works best in bear markets and when buying securities with dramatic price swings. If you have a large amount of money, you're better off investing it as soon as possible because uninvested cash isn't working to build your net worth.
• Paying higher fees. If you invest with a broker who charges a fee for every transaction, you'll make several transactions and incur high transaction costs. For example, if your monthly contribution is $500 and your brokerage charges you $10 for every transaction, that represents a 2% transaction fee. These costs add up over time and can offset your accrued gains, so most investors prefer to passively manage low-cost index funds with lower percentage-based fees.
• Knowing how to choose quality investments. The dollar-cost averaging strategy doesn’t solve all investment risks or spare you the work of choosing good assets to invest in. If the investment you identify turns out to be a bad pick, you’ll only be investing steadily into a losing investment. Also, by adopting a passive approach, you’ll be unresponsive to the changing environment and can miss out on new market opportunities.

Examples of dollar-cost averaging

There are multiple different ways investors can use the dollar-cost averaging method. For example, companies deliver contributions to a 401(k) account once during every pay period. Those contributions are made automatically regardless of market conditions unless the employee actively changes the investment fund or contribution amount.

Also, many online investment brokerages allow users to set up automatic contributions for set intervals and with fixed contribution amounts. This allows investors to automatically make predetermined contributions without having to think about it. This course of action minimizes the risk of investors hesitating due to poor market conditions or jumping from one stock or fund to another based on trending information.

A third common example of DCA is dividend reinvestment. Financial advisors and brokerages can automatically reinvest any dividends your investments receive as soon as those dividends reach your account (after each quarter or on an annual basis, based on the particulars of the investment). This systematic approach also provides you with the ability to consistently invest money without timing the market.

How to use dollar-cost averaging

The process of setting up dollar-cost averaging for your accounts is straightforward. Simply set up an automatic buying plan with your broker. If your brokerage account doesn't offer an automatic trading plan, pick a regular date (say the first Monday of the month) to go to your broker and buy the stock or fund. Here are a few tips to help you get started with DCA:

• Choose your investment. Do your research and make sure you pick the right thing to invest in. Certain investments like mutual funds and exchange-traded funds best suit this strategy.
• Decide how much money to invest. Figure out how much you can devote to investing — even if it's not a lot at first, the most important point is to begin investing regularly. This means you'll need to be able to live on your uninvested money during that time, so budget how much you can reliably afford.
• Determine how often you want to invest and commit to it. This can be daily, weekly, monthly or any interval you want. Then, you need to stay focused. Remember that you committed to purchasing it regularly, no matter how bad the asset's performance is on a given day or week.

Wrapping up

Dollar-cost averaging works by putting a fixed amount of money in the market at regular intervals rather than one large lump sum. It allows you to buy more low-priced shares when the market is down and fewer high-priced ones when it is up.

This investment strategy is ideal for investors who don't have tons of cash to invest right away, have a low-risk tolerance, and don't want to concern themselves with the ups and downs of the market.