What Is Dollar-Cost Averaging?
Dollar-cost averaging is an investment strategy that involves investing a specific amount of money in a particular asset at regular intervals over a length of time—regardless of changes in that asset’s price—to reduce the impact of price volatility on the investor’s average cost.
For instance, instead of investing $1,000 in Tesla at one time, someone using dollar-cost averaging might invest $50 in Tesla at the same time every week for 20 weeks. This way, their average cost per share of Tesla by the time they invest the total $1,000 should be somewhat similar to Tesla’s average stock price over the course of the 20-week period during which they were investing. By choosing to invest small, equal amounts of the lump sum they’ve decided to put into Tesla stock over time, this investor can shield their investment from short-term volatility in the price of Tesla stock.
How Does Dollar-Cost Averaging Work as an Investment Strategy?
With dollar-cost averaging, the same amount is spent at every interval regardless of a security’s current price. This means that when a security’s price is lower, more total shares are purchased, and when a security’s price is higher, fewer total shares are purchased. This takes the guesswork out of periodic investing by guaranteeing that an investor buys more of something when it’s cheap and less of it when it’s expensive.
How Does Dollar-Cost Averaging Protect Against Volatility?
This strategy allows investors to minimize the risk associated with a security’s short-term volatility. By purchasing in the same dollar amount regularly, investors can lower their chances of accidentally “overpaying” for an asset by putting their lump sum in it all at once at an inopportune moment.
For this reason, dollar-cost averaging is a good strategy for passive investors who have a good idea of where they want their money allocated but don’t necessarily have the time or resources to study the market constantly and make trades on a frequent and opportunistic basis. It is also a good strategy for investors who know how to identify value in businesses but don’t necessarily believe the stock market is predictable in the short term.
What Kinds of Investors Use Dollar-Cost Averaging?
Many different types of investors use dollar-cost averaging as a way to mitigate the effects of volatility on their portfolios. That being said, the strategy is probably best suited to long-term value investors and passive investors who prefer to minimize risk while seeking moderate but relatively consistent returns. Most folks who use employer-provided 401k accounts to save for retirement employ dollar-cost averaging without even knowing it. Whether you choose your own investments or select one of the default options offered by your employer, as long as the same percentage of your paycheck is allocated to the same basket of securities each pay period, you are dollar-cost averaging simply by contributing to your 401k with each paycheck.
Dollar-Cost Averaging vs. Lump Sum Investing (AKA Timing the Market or “Buying the Dip”)
Why would an investor choose to use dollar-cost averaging? Isn’t it better to buy low and sell high? If a security went up in price while an investor was using dollar-cost averaging to purchase it, wouldn’t they make less money than if they had just invested their entire lump sum at the beginning?
In theory, yes, an investor could make more money by buying low and selling high than by buying an asset periodically as it goes up in price. That being said, no one can know for sure when a security is going to go up or down in price—especially in the short term.
On the other hand, it is relatively safe to assume that most large, healthy, publically traded companies’ stock prices will go up, generally speaking, in the long term (let’s say 5+ years). That’s why DCA is a good strategy for more passive investors interested in long-term capital gains.
Neither strategy is inherently better than the other, but each is better suited to a different type of investor.
Seasoned day traders and other risk-friendly market-watching investors who buy and sell securities daily to take advantage of short-term price changes may well prefer lump-sum investing despite the risks it carries.
Risk-averse investors who plan to buy and hold for long-term returns, on the other hand, can use dollar-cost averaging to minimize the effects of short-term volatility on their portfolios while consistently investing in businesses that are likely to perform well over time. Perhaps most importantly, they can do this without constantly watching the market.
Dollar-Cost Averaging Example: AAPL
Let’s say an investor had $1,000 they wanted to invest in Apple (AAPL) in October of 2020. If they used dollar-cost averaging to spread their investment out over 10 months, they would buy AAPL $100 dollars at a time. See the table below.
By dollar-cost averaging, an investor spending who spent $1,000 on AAPL over 10 months by investing $100 halfway through each month beginning on10/15/20 and ending on 7/15/21 would end up with 7.80 shares at an average cost of 128.20 per share. This means that as of 7/15/21, this investor would have made around $164.
If the same investor spent the entire $1,000 on AAPL on 10/15/20, they would have 8.42 shares of AAPL at an average cost of 118.72 per share. This means that the investor in question would have more shares of AAPL and a lower average cost had they invested the $1,000 as a lump sum at the beginning. This means that as of 7/15/21, this investor would have made around $256.
If they spent the $1,000 on 2/15/21, however, they would have 7.3 shares at an average cost of 135.49 per share. This means that the investor would have fewer shares and a higher average cost if they invested the $1,000 as a lump sum in February of 2021. This means that as of 7/15/21, this investor would have lost around $11.
This example illustrates the nature of dollar-cost averaging well. It’s not always the best way to maximize returns, but it does take the guesswork out of market timing. Hindsight is 20/20, so it’s easy to look at this example and say that the hypothetical investor should have put their lump sum in AAPL in October of 2020, but due to AAPL’s short-term price volatility, this investor would have had no sure way of knowing how AAPL stock was going to perform over the next 10 months. Additionally, if this investor was a real person, they may not have had $1,000 lying around in October of 2020.
What Are the Risks and Drawbacks Associated With Dollar-Cost Averaging?
While dollar-cost averaging is a good way to mitigate short-term risk, it may not be the best long-term investment strategy when it comes to maximizing returns. The market tends to go up in value over time in the long term, and healthy businesses tend to go up in value with it. In a healthy market, investors using dollar-cost averaging may miss out on returns by raising their average cost per share with each incremental investment instead of investing a lump sum as early as possible.
Some investment platforms charge a fee for each trade. While a lump-sum investor would be required to pay this trading fee just once, an investor using dollar-cost averaging would have to pay this fee with every incremental investment.
Money held in cash or cash equivalents (checking accounts, etc.) doesn’t typically earn interest. In fact, it may lose value due to inflation. By keeping some money in cash so that it can be invested incrementally, an investor relinquishes the opportunity to allow that money to grow by putting it in a stock, fund, or bond.
Pros and Cons of Dollar-Cost Averaging
Is Dollar-Cost Averaging Right for Me?
If an investor had a large amount of capital available and chose to use dollar-cost averaging instead of lump-sum investing, they would miss out on returns if the market rose by keeping some of their money in cash instead of allowing it to earn by throwing it all at the market to begin with.
That being said, if the market experienced a downturn, an investor using dollar-cost averaging would lose less money than someone who invested a lump sum before the crash, and they would be in a better position to recoup their losses and realize capital gains once the market turned around.
Additionally, many investors do not have a large amount of capital available at any given time. For those who need to invest on an incremental basis as they earn disposable income, lump-sum investing, at least in large amounts, may be out of the question.
Many investors who invest periodically do so via 401k accounts or similar investment accounts as they earn money. These investors can choose to engage in dollar-cost averaging by leaving the percentages of each security in their portfolios alone, or they can keep an eye on the market and reallocate funds to different securities as they go if they believe they can maximize their returns by doing so.
Ultimately, whether or not you should use dollar-cost averaging should depend on how risk tolerant you are, how much money you have available to invest at once, and how much time and attention you can devote to studying stocks and the market at large.
Many investors maintain multiple portfolios so they can test out different investment strategies at once. Maintaining imaginary portfolios to play with different investment strategies can be a good way to figure out what works for you and what you’re comfortable with.
Frequently Asked Questions (FAQ)
In this section, we’ll go over the answers to some of the most common questions investors have about dollar-cost averaging.
Does Dollar-Cost Averaging Really Work?
Dollar-cost averaging does work in that it usually does what it is supposed to do—minimize the impact of short-term price fluctuations on an investor’s average cost. That being said, risk -minimization is not every investor’s goal. Risk-friendly, market-watching investors seeking the highest returns possible would do likely do better with carefully timed lump-sum investing.
Is Dollar-Cost Averaging a Good Investment Strategy for Cryptocurrencies?
Much like in the stock market, dollar-cost averaging can be used in the crypto market to mitigate the effects of price volatility. The crypto market is notoriously volatile, so dollar-cost averaging could be a good strategy for long-term crypto investors and those who want to invest in crypto passively. Most crypto exchanges (like Coinbase and Robinhood) allow users to set up recurring investments, so dollar-cost averaging can easily be automated.
That being said, the volatility of the crypto market also makes lump-sum investing attractive to some market watchers, as massive gains can be realized if dips and peaks are properly timed.
How Often Should You Invest When Dollar-Cost Averaging?
The more frequently you invest, the less price volatility affects your average cost. In other words, the more worried you are about volatility, the smaller your investment interval should be. Investing on a daily basis, however, isn’t necessarily the best route for most folks.
Assuming you have $300 to invest per month, investing $10 per day would keep your average cost very close to your target security’s average price over the period during which you are investing. This means your capital gains (and/or losses) would probably be very limited.
Investing $300 once a month, on the other hand, would allow you to buy significantly more shares when prices drop and significantly fewer when they rise, so your potential gains (and/or losses) would be more noticeable.
Most folks who use this investment strategy do not invest on a daily basis. Investing once or twice a month is far more common. Those who employ DCA via a 401K or IRA tend to contribute once every two weeks with each paycheck they receive.
When Should You Stop Dollar-Cost Averaging?
Dollar-cost averaging can be done for a set period or in perpetuity. Those who dollar-cost average using their retirement accounts often continue to do so until retirement, although they may change what they invest in periodically.
If you assume the business or fund you’ve invested in is going to continue to increase in value in the long term, it would be prudent to continue investing for as long as possible so as to take advantage of price dips as they occur to lower your average cost.
On the other hand, if you believe the business or fund you’ve invested in has reached its maximum value, discontinuing your investment and selling your shares would be prudent. This is easier said than done, however, as most businesses aim to grow indefinitely, and figuring out when a business has reached its peak in terms of value is no easy task.
Does Dollar-Cost Averaging Work in a Bear Market?
A bear market is actually one of the best scenarios in which to employ dollar-cost averaging if you plan to buy and hold. As stocks go down in price, your weekly or monthly investment buys you more of them, lowering your average cost.
The lower your average cost, the more you stand to make when the market turns around and stocks go back up in value. By dollar-cost averaging, you ensure that the losses you experience during a bear market are minimized because you keep buying as prices fall. In other words, dollar-cost averaging during a bear market is a relatively safe and sensible way to “buy the dip.”
Does Dollar-Cost Averaging Work in a Bull Market?
In a bull market, dollar-cost averaging may not be as effective. If a stock, a fund, or the market at large goes up consistently for some time, dollar-cost averaging would result in minimal returns compared to investing a lump sum toward the beginning of the bull run.
