Connect with us

What Is Dollar-Cost Averaging? Why It Pays Off for Most Investors

Investing

What Is Dollar-Cost Averaging? Why It Pays Off for Most Investors

You want to buy low and sell high, but guess what? So does everyone else.

If we all had time machines, of course we’d go back to March 23, the day the S&P 500 reached its low and throw money into the stock market. If you’d invested in an S&P 500 index fund then, you’d be 50% richer today.

But none of us knew on March 23 that we’d reached bottom.

Then the stock market rallied, even as the economy sputtered. Now there’s lots of talk that the market may be overpriced.

So how are you supposed to buy low when prices are high? And how do you avoid overpaying when you invest in stocks?

Reality check: You’re not always going to buy low. You should worry more about the risk of always buying high — which often happens when you invest based on what the stock market is doing. By the time you feel confident enough to invest following a crash, prices have already risen.

The best way for most beginning investors to navigate the stock market is to ignore it altogether using a strategy called dollar-cost averaging.

What Is Dollar-Cost Averaging and Why Is It a Good Idea?

Suppose you had $12,000 cash to invest. You could invest it all at once in a lump sum. Or you could spread your purchases out, say by investing $1,000 each month or $3,000 every quarter for a year.

If you did the latter, you’ve chosen the dollar-cost average approach.

Here’s how dollar-cost averaging works: You decide how much you’re willing to invest, and you invest the same amount in fixed intervals. You could invest every month, every quarter, even every year. Usually the simplest approach is to make a budget and then automatically invest a certain amount every month.

The big advantage of dollar-cost averaging is that it smoothes out the average cost of investing over time. You’ll pay more for investments when the market is up. But you’ll also get those bargain prices following a crash. Often your average cost over time is lower as a result.

It’s usually a better strategy than market timing, which is making decisions based on what you think the market will do. Some investors think they can pull out their money right before a crash, then jump back in when it’s safe. Or they stop investing during a downturn, which is a surefire way to make sure you always pay top dollar for your investments.

Study after study shows that market timing is a losing game. The best days of the stock market often happen shortly after the worst ones. If you invested $10,000 in an S&P 500 index fund in 1999, you would have had close to $30,000 at the end of 20 years, according to a J.P. Morgan Asset Management analysis. Your average returns would have been 5.62%.

But if you’d missed the best days — and six out of 10 occurred within two weeks of the 10 worst days — you would have had average returns of 2.01%, leaving you with about $15,000.

The consistency of dollar-cost averaging takes the emotion out of investing. You aren’t trying to make big decisions about your money in a panic when the market is down or FOMO when it’s up. Many financial planners also like dollar-cost averaging because it makes you a more disciplined investor.

If you contribute to a 401(k) plan, you’re already practicing this strategy. You invest a percentage of each paycheck regardless of the stock market’s performance. When the market is down, your money buys more shares. When it’s up, your money buys fewer shares. Same goes for if you automatically fund a Roth IRA or traditional IRA.

How Dollar-Cost Averaging Works: An Example

Getty Images

Pretend you had invested in stocks at the beginning of January 2020. You paid $9,000 in a lump sum for an imaginary stock that moved perfectly in sync with the S&P 500. You paid $100 per share, so you got 90 shares.

Now imagine that instead of investing that lump sum, you’d used dollar-cost averaging, so you invested $1,000 at the beginning of each month.

Month Amount invested Shares purchased Price per share

January $1,000 10 $100

February $1,000 10 $100

March $1,000 10.5 $95

April $1,000 13.33 $75

May $1,000 11.5 $87

June $1,000 10.6 $94

July $1,000 10.5 $95

August $1,000 9.9 $101

September $1,000 9.25 $108

If you could predict the future, you’d have invested it all in a lump sum in April right after the market imploded. But since you accepted your lack of psychic powers, you decided to do the next-best thing. You practiced dollar-cost averaging.

Instead of paying $100 for all of your shares, you got some for a bargain in April at $75, but you also bought some relatively expensive shares for $108 in September.

Your average cost per share over the nine-month period: $94.16.

“But wait!” you say. Why couldn’t I have invested everything in a lump sum on March 23, when prices were lowest? You would have paid just $68 per share. Remember: You’re not psychic. This strategy only works if you have the clairvoyance to pinpoint the exact moment when prices tumbled as far as they’re going to go.

Does Dollar-Cost Averaging Protect You From Losing Money?

Dollar-cost averaging only works if you stick with it when things get really bad. If you dollar-cost averaged for years and then stopped investing in March, April and May, you missed out on all the benefits of this strategy. You got cold feet and didn’t scoop up those low-cost shares.

But as with any investment strategy, dollar-cost averaging only works if your investment gains value over time.

If you invest in a company that goes under, it won’t matter how disciplined you’ve been about dollar-cost averaging. Your shares will still be worthless.

The tricky thing is that you have to strike a balance. Monitoring the daily fluctuations of your investments is a bad idea. But you shouldn’t set everything on autopilot, either.

If you’ve invested in a company that’s consistently losing money, it may be time to cut your losses. Or if your portfolio is underperforming compared to the overall market, you should review your asset allocation, including your mix of bonds vs. stocks.

Dollar-cost averaging removes a lot of the stress surrounding your investments, but it’s not a set-it-and-forget-it strategy. While it provides you a safety net from market volatility, it doesn’t protect you from losing money.

Does Lump-Sum Investing Ever Make Sense?

When we talk about dollar-cost averaging, we’re assuming you’re not sitting on a boatload of cash. But if you have significant savings beyond the recommended three- to six-month emergency fund, investing it in a lump sum may make sense.

Dollar-cost averaging protects you against shorter-term price volatility. But if you won’t need the money in the next few years, you’re better off just investing it in an exchange-traded fund that’s indexed to the overall stock market. Investing across the stock market is a good move because it gives you an automatically diversified portfolio.

Your returns will vary, but they average 7% to 8% when you adjust for inflation. You’ll benefit from giving that money as much time to grow as possible.

Another time lump-sum investing makes sense is when you have a one-time windfall, like a tax refund or bonus. Investing it all at once beats spending it on things you don’t need.

Lump-sum investing usually makes sense as a supplement to dollar-cost averaging: You need to invest consistently, but when you find yourself with extra money, investing it in a lump sum makes sense.

The bottom line: You won’t always buy low. Sometimes you’ll buy high. What matters most is that you can sell even higher. The best way to make that happen is to practice dollar-cost averaging and give your money plenty of time to grow.

Robin Hartill is a certified financial planner and a senior editor at Codetic. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected].

More in Investing

To Top