You may not have heard of “dollar-cost averaging,” but there’s a good chance you’re using that method to invest.
And that’s a good thing. Dollar-cost averaging has the potential to reduce the average price you pay per share when investing in the stock market, increasing your potential for profit and reducing some of the short-term volatility associated with investing.
Below, we define dollar-cost averaging, give an example of its power in action and compare it against other common investment strategies.
What is dollar-cost averaging?
Dollar-cost averaging (DCA) is simply the practice of investing a specific amount of money on a regular schedule—say, weekly, biweekly or monthly—no matter how the stock market is performing. Whether the market is up, down or relatively flat, an investor who is practicing dollar-cost averaging would continue to make the same periodic investments.
In other words, with dollar-cost averaging, consistency is the name of the game.
The benefit of this approach is that when prices are high you will naturally purchase fewer shares, and when prices are low you will naturally purchase more shares—all without consciously needing to think about or adjust your investment strategy. That means that, over time, you have the potential to lower your average cost per share compared to what you may have paid if you bought all of your shares at once.
You may be practicing dollar-cost averaging already, for example, with your 401(k) or other employer-sponsored plan as pre-tax money is usually taken out of each paycheck and deposited into your retirement investment account. (If you use Round-Ups or Recurring Investments with Acorns, you’re also taking advantage of this practice.)
“If you invest regularly, you’re dollar-cost averaging,” says Certified Financial Planner Gary Silverman, founder of Personal Money Planning in Wichita Falls, Texas. “By investing regularly and at varying prices, you increase your potential to profit—even if an investment’s long-term returns are relatively flat.”
Dollar-Cost Averaging in Action
For example, let’s say that shares of an exchange-traded fund (or ETF) cost $20 at the beginning of the year (January 1) as well as at the end of the year (December 31). If you had invested a single lump sum all at once on January 1, then a year later your investment would be virtually flat (minus any dividends that may have been paid out).
But in all likelihood, over the course of the year, that price has fluctuated. Had you practiced dollar-cost averaging and split up your investment into smaller, regular investments, it is possible that you could have purchased more shares when the price was lower and fewer shares when it was higher, ultimately capturing some gains that you would have missed out on had you invested all at once.
Take this hypothetical chart, for example, where the stock price sits at $20 for three months out of the year, dips below $20 for seven and only increases for two months:
Shares Purchased With $1,000
As a result, the average share price is actually $18.88—meaning the average amount you paid for a share is $1.12 less (or over 5 percent less) than what you’d pay if you invested the full $12,000 in January.
Yes, share prices could have risen a lot in between those two dates instead, and you may have ended up paying a little more on average, but trying to time the market is extremely hard.
Dollar-cost Averaging vs. Lump-sum Investing
Proponents of lump-sum investing often justify their strategy by pointing out that the market has trended up over the long term—and substantially so. Just look at any historical chart to see this idea in action.
Therefore, it could be argued that if an investor has a large sum of money, he or she would be better off to simply invest all of that money at once because it will maximize the amount of time that the investment will be in the market. Indeed, some research by Vanguard does suggest that investors pursuing a lump-sum strategy could lead to somewhat higher average gains than those pursuing dollar-cost averaging.
But this research (and this argument) ignores a few important things.
First and foremost, when people point out that a lump-sum investment might outperform dollar-cost averaging, the argument presumes that you have a lump sum to invest. If you don’t, the argument simply doesn’t apply to you.
Second, lump-sum investing often leads to increased volatility. Because the investment is made at a single price point, when that price changes, for better or worse, the value of the investment can fluctuate—sometimes wildly.
Zoom in on any of those historical charts, and you’ll see lots of ups and downs along the way. Though historically the market trends up, it is very rarely a smooth ride to the top, and this volatility can be detrimental to investors who do not have a high tolerance for risk and who might be prone to panic selling when prices drop.
Because dollar-cost averaging spreads out your investment among various price points, the effect is to smooth out some of this volatility. It won’t remove the volatility completely, but dollar-cost averaging, paired with an appropriately diversified portfolio, can substantially reduce the valleys and peaks your portfolio experiences, making it more likely that you will stick with your investment strategy over the long term. Even the Vanguard report suggests that dollar-cost averaging can minimize losses compared to lump-sum investing in the worst of markets.
Dollar-cost Averaging vs. Value Averaging
Another investment strategy that is often compared to dollar-cost averaging is value averaging.
With value averaging (or dollar value averaging, DVA), an investor will make regular investments to their portfolio over time. But instead of investing the same amount of money each week, month, or quarter, they set a specific value that they want their portfolio to reach. The current value of their portfolio in relation to that goal, then, determines how much money they invest at any given time.
For example, if an investor wants to have a portfolio worth $1,200 in a year’s time, they might start with a $100 investment the first month, with a goal of increasing the portfolio’s value by $100 each month thereafter.
If the value of the portfolio remains the same in the second month, then the investor would put in another $100. But if the investment has risen by, say, $5, then the current value would be $105. The investor would then only invest $95, in order to bring the total portfolio value up to their goal. On the other hand, if the value of the portfolio went down to $95, then the investor would invest extra—a total of $105—to bring the total value of the portfolio up to its goal level.
The thinking behind this is similar to what guides dollar-cost averaging: Following this strategy allows you to purchase more shares of an investment when prices drop, and fewer when prices rise, with the goal of maximizing your profit. But it takes more effort than simply setting up a regular investment at a set amount.
What are the advantages of dollar-cost averaging?
1. It’s relatively simple.
Following a value averaging approach requires an investor to pay a lot of attention to the market and how their portfolio is performing, which simply makes the process a lot more complicated than it has to be. That complexity can discourage investors from getting started, or from continuing to invest for the long haul. Who really wants to deal with the hassle of adjusting 401(k) withholdings on a monthly basis?
Compared to value averaging, dollar-cost averaging is simple. Just figure out how much money you want to invest on a regular basis and commit to that schedule. You can even automate your investments to completely take the thinking out of the equation.
2. It doesn’t encourage trying to time the market.
The whole premise of value averaging as an investment strategy is built on the idea of timing the market, which is notoriously difficult to do. Even professional traders who try to time the market fail more often than not, missing out on gains and locking in losses that could have been avoided had they simply followed a consistent investing approach.
In value averaging, an investor will often wind up with a cash surplus whenever the market performs well, because they are investing less money during those time periods. In a best-case scenario, this cash will sit in a savings account, where it might earn 1 to 2 percent interest; in a worst-case scenario, the cash might be spent on non-wealth-building activities.
In either case, the investor is not fully invested, which means that they’re missing out on potential gains.
Regularly investing a set amount of money each week or month allows you to put your money to work as soon as you earn it and decreases the amount of cash sitting in your savings account earning relatively little.
3. It removes the emotional aspects of investing.
Finally, dollar-cost averaging can help take the emotion out of investing because you’re investing the same amount of money each period no matter how the market is performing. You don’t even need to actively pay attention to the market—which can help you stick to your plan.
The danger of paying too much attention to the market, as is required in value averaging, is that people are often driven by emotion. Seeing the value of your investments drop substantially can cause anxiety and trigger panic selling, which locks in your losses. Following a disciplined approach with dollar-cost averaging can help you stay the course, even in volatile times, and avoid making an emotionally driven decision you might later regret.
“People have a tendency to feel more comfortable investing if the market has been going up for quite a while and feel less comfortable after it has gone down. But this is generally the exact opposite of what you should be doing,” Silverman says. “Dollar-cost averaging allows investors to get past this tendency.”
Make Dollar-Cost Averaging Work for You
Of course, dollar-cost averaging doesn’t guarantee you’ll make a profit or never lose money—no strategy can do that. But it’s a smart way to take advantage of the market’s natural fluctuations and start establishing good investing habits.
Below are a few tips that can help you get as much value as possible out of dollar-cost averaging:
Keep an eye on costs. Compared to lump-sum investing, dollar-cost averaging typically involves making more transactions over the course of your investment timeframe, which can really add up depending on your schedule and investment frequency. To combat this, look for investment opportunities with low or no trading fees.
Don't be too hands off. One of the benefits of dollar-cost averaging is that investors don't have to pay attention to daily/weekly fluctuations of the market, which can remove the risk of emotional decisions. But it is still a wise idea to check in once or twice a year to see how your portfolio is performing and to determine whether or not you should rebalance your investments in any way.
Don't give up. The real value of dollar-cost averaging is that it gets you in the habit of investing regularly over time. If you abandon the strategy when prices drop, you are missing out on potential gains.