Dollar-Cost Averaging: Protect Your Money From Volatility

When you have money to invest, you might be wondering which investment strategy will minimize your risk and maximize your reward. You've probably heard that it's best to buy low and sell high, but in practice, it's very difficult to time the market. 

Dollar-cost averaging (DCA) takes away the guessing and allows you to consistently invest equal amounts of money. DCA aims to reduce the impact of volatility by averaging market fluctuations (and you may even already be using it). 

It's important to note that dollar-cost averaging also applies to selling — you can attempt to smooth out market fluctuations by selling your investment, RSUs in your company for example, at consistent intervals. Though we'll refer to buying for most of the article, just note that the underlying idea is the same.

What Is Dollar-Cost Averaging?

Also called the constant dollar plan, dollar-cost averaging is an investment strategy that invests equal amounts in the stock market at regular intervals. This strategy is contrasted to lump-sum investing where you pour a large sum of money into the market at once.

Lump-sum investing can be risky if you don't time the market well. So, if you're given a large sum of money, say a bonus or inheritance for example, you could invest it all at once or you could use dollar-cost averaging.

"When you dollar-cost average, you 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 paying a lower average price per share over time," explains FINRA.

This method works best in bear markets, where you can purchase stock at low points when investors are less likely to buy. Dollar-cost average investors buy when the market is temporarily dipping down to capitalize on the lower prices, since many other investors will sell their shares for a lower price. Then the average dollar amount smooths out over time, providing you with a regular long-term investment.

An Example: Dollar-Cost Averaging with ETFs

Let's say you have $2400 to invest in ETF. You could invest all of it at once, or you could invest $200 per month over a year-long period. Utilizing this method, you could potentially wind up with more shares than investing everything at once by capitalizing on market fluctuations.

Dollar-cost averaging is a long period investment strategy that prevents an investor from buying high or selling low. Instead, it evens out their investments over a longer period of time.

Dollar-Cost Averaging In Action

Dollar-cost averaging gets its name from the idea that it reduces the average cost of shares that an investor buys. Because the number of shares that you can buy for a given amount of money varies, dollar-cost averaging will let you buy more shares when the price is low, and fewer when shares are more expensive. That way, DCA lowers the total cost per share of the investment. 

The dollar-cost averaging investor decides on the fixed amount of money to invest, and the period of time over which the investments will be made.

Investing over short-term periods is more similar to lump-sum investing, where an investor puts all of their money into the market at the same time. While this has the potential to be more lucrative, it is also a much riskier endeavor if you time the market wrong. Over time, your average cost per share when you utilize dollar-cost investing often compares favorably to the price you would have paid if you’d tried to time your investment for one lump sum.

Because the purchases happen regardless of an asset’s price, and they happen at regular intervals, the dollar-cost averaging strategy removes an investor’s worry of timing the market to make purchases at the best prices. It takes the emotion out of the investment process, too, as you can’t panic and sell all your shares at once. 

Using Dollar-Cost Averaging: Who, When and How

Who?

If you have a 401(k), IRA, or other retirement plan, you are likely already utilizing dollar-cost averaging. Dollar-cost averaging can also be used in mutual fund accounts or index fund accounts separately from retirement accounts.

Dollar-cost averaging is typically ideal for:

• People who don't want to invest all of their money at once, or don't have a large sum to invest at once.
• People who want to reduce their exposure to market volatility and smooth out the average price.
• Beginners in exchange-traded funds or ETFs. According to Investopedia, dollar-cost averaging helps beginners learn discipline as they begin to save by investing the same fixed-dollar amount in an ETF each month.
• People who want to take the thinking out of investing and want to invest with ease over the long term.

When?

Bear markets, or declining markets, are the most useful time to make a profit using DCA, as you are buying individual stocks when many other investors are selling. It’s a long-term strategy, however, and part of DCA investing means that you invest a fixed amount regardless of what the market looks like on any given day. There is no particular day of the month considered the best for regular investments. 

👉 Read Next: Bullish vs Bearish: What's the Difference?

How?

Dollar-cost averaging can be applied to all types of securities, but it’s most common to use DCA for pooled investment vehicles, including mutual funds, index funds, and exchange-traded funds (ETFs).

You can set up a plan with a brokerage and purchase individual stocks, exchange-traded funds and other financial asset classes. You can set up your brokerage plan to buy automatically at regular intervals, which you can do regardless of whether or not your brokerage account offers an automatic trading plan. You can also choose a recurring payment at the same time every month. Keep investing regularly, keeping an eye out for advantages in declining markets, regardless of stock prices.

So Does It Work?

Many conversations circulate in the financial world about the pros and cons of dollar-cost averaging over lump-sum investing, and there are scenarios in which one has advantages over the other.

Research from the Financial Planning Association and Vanguard from 2004 found that over the very long term, dollar cost averaging underperforms lump-sum investing. However, FINRA states that while a Vanguard study found that lump-sum investments outperformed dollar-cost averaging, it did so only 66 percent of the time.

👉 Note that these findings don’t apply to an IRA or 401(k) because in those accounts, you invest money as you earn it rather than holding it for a later date.

So, if you're given a bonus or inheritance, it could be ideal to lump-sum invest rather than use dollar-cost averaging. On the other hand, most of the time, you don't have a lump sum to invest. Setting money aside until it becomes a large sum rather than investing as you earn it can cause you to miss the potential gains of DCA and fall victim to inflation.

Reach out to a financial advisor to figure out if DCA sounds right for your investment portfolio and comfort level with the market.

Benefits & Drawbacks of DCA

Benefits

• Influences investor psychology: DCA positively influences investor psychology, as it’s a regular investment that does not change, and takes away an investor’s decision to buy more in times of good fortune or panic when the market fluctuates downward. DCA helps an investor ignore the emotional responses of fear and recklessness.
• Reduces the effect of market timing: DCA prevents lump-sum investments at inopportune times. If you mistime a lump-sum investment, that’s a lot of money gone at once. However, with DCA, you’re able to remain consistent and think longer-term about your investment strategy.
• Invest small amounts of money: The ability to invest smaller amounts of money can be a powerful tool for people who have less money to invest overall.

Drawbacks

• Modest gains: Because DCA is meant to protect investors from stock market volatility, its risks are not high. Lump-sum investing can often lead to greater gains, while DCA’s gains are more modest and a part of a long-term investment strategy. If you’re looking for a short-term investment to make a profit quickly, DCA is not the investment strategy for you.
• Lump-sum investing may be better for large sums: If you have a large sum available to invest, lump-sum investing may be the best option to make a larger profit, and you’re better off investing it as soon as possible, assuming that market timing is in your favor.
• More trading costs: Another downside is that buying stocks more frequently adds to trading costs. However, brokerages are frequently charging their clients less to trade, so the expense is not exorbitant.

Takeaways: The Bottom Line

Dollar-cost averaging can be a useful tool to split up investments over time. It is also useful for beginning investors who may feel less confident in their ability to invest a lump sum; you can start with dollar-cost averaging and work up to more varied investment strategies.

Remember that dollar-cost averaging is a long-term investment strategy, and you will not see major profit immediately. If a bear market or a bull market lasts for months or years, that reduces the value of DCA, but if you are in it for the long haul, DCA can still pay off eventually. Mutual funds and individual stocks generally do not change in value drastically each month, so it will take time for your assets to generate value.

If you’re only interested in short-term investments, or you enjoy figuring out timing, research, and the intricacies of the stock market, another investment strategy may serve you better. However, if you are a beginner with less to invest and you are already making regular investments in retirement accounts like 401(k)s or IRAs, DCA may be the investment strategy for you.