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What Is Dollar Cost Averaging?
Dollar cost averaging refers to regularly investing a set amount of money, regardless of price or market performance.
Contributing to an employer-sponsored retirement account, like a 401K, is where many of us have experience with dollar cost averaging. In the case of the 401K, you contribute a fixed amount of money from each paycheck that gets allocated across funds of your choosing.
You can deploy dollar cost averaging across many areas of investing. For example, it can be used when investing through a Roth IRA, adding to stock positions and funds in a brokerage account, or purchasing bonds.
There is no defined interval on how often you must invest, just that it is done regularly. Most people think of it as occurring per paycheck or monthly, but it doesn’t need to be that way. Let’s look at two different scenarios of dollar cost averaging.
Scenario 1
This year, you aim to invest $6,000 into an S&P 500 fund through a Roth IRA. You are deciding between investing $500 each month or $1,500 each quarter. Both will get you to $6,000, and both are considered dollar cost averaging.
Scenario 2
You received a $12,000 bonus at work and are looking to invest. You want to use that money to buy shares of Tesla but are worried about making a $12,000 lump sum purchase in case the shares go lower. Instead, you use dollar cost averaging and purchase $1,000 of Tesla stock monthly for twelve months.
Now that we covered the basics, let’s move on to four pros of dollar cost averaging.
1. Dollar Cost Averaging Guards Against Emotions
Investing is emotional. How could it not be? You are taking hard-earned money and placing it into investments that you hope will lead to a solid rate of return. It is challenging to set aside your emotions, no matter how rational you are.
You can feel euphoric when your portfolio grows exponentially during a bull market. But that euphoria can quickly turn to disappointment and fear when you see your portfolio tumble during a bear market. Both situations can cloud your judgment and lead to poor decisions.
Dollar cost averaging does not let your emotions get in the way of a sound financial strategy.
Dollar cost averaging guards against these emotions by stopping you from pouring too much money into the market when it is peaking. Those are the times when the endorphins are pumping, and you feel like the good times will never end. It also prevents you from pulling out when the market hits rock bottom, and you are scared the sky is falling.
Dollar cost averaging played a significant role for me during the dark days of the Great Recession. I stayed invested and never decreased or stopped my regularly scheduled contributions. Was I scared? You bet but think of how much worse off I would have been if I had let my emotions stop me from investing. I would have missed some of the best trading days during the longest bull market in history.
Speaking of the Great Recession, this leads us to our next pro of dollar cost averaging: risk reduction.
2. Dollar Cost Averaging Reduces Risk
Dollar cost averaging reduces risk by spreading out your purchases instead of making one big lump sum play on a stock or security. This smooths out risk because you buy fewer shares when the market is up and more shares when the market is down. To illustrate this point, let’s return to the scenario where you decided to invest a $12,000 bonus in Tesla using dollar cost averaging.
If you invested $1,000 monthly in Tesla in 2022, you would have bought only 3 shares in January when the stock was at $312. You would have purchased even fewer shares in March when the stock peaked for the year at $359. However, when Tesla tanked later in the year, you would have bought 5 shares in November at $194.7 per share and 8 in December at $123 per share.
By year-end, your average cost per share would have worked out to $240. You would have suffered a 23% loss. That stinks, but what would have happened if you made a $12,000 lump sum purchase of Tesla stock in January when it was at $312? You would have been down over 60% on the year. By using dollar cost averaging, you were able to limit your downside risk.
Of course, you could have also invested the $12,000 when Tesla hit its low of $123, maximizing your upside potential. This is called market timing and leads us to our next pro of dollar cost averaging.
3. Dollar Cost Averaging Eliminates Market Timing
Market timing is probably the most straightforward investment strategy to explain. It is about timing the market, so you buy low and sell high. That is it. Super easy, right? But there is a big problem; it is easy to explain but very difficult to implement.
The problem is you have to be able to predict the future, and I have yet to meet one person who can. That does not stop money managers, economists, and everyone else from predicting where the market or a stock is heading. Occasionally they are correct, but if you are constantly making predictions, you are bound to be right sometimes.
Check out the 12-month price forecast of your favorite stock. Analysts are constantly revising their forecasts, and the predictions across the analysts can vary substantially.
I viewed the stock price forecast of Nvidia at CNN Business. Over 30 analyst cover Nvidia and the forecasted stock price ranged from a low of around $392 to a high of $1,100. Let that sink in. How will you be able to time the market if even the most intelligent analysts covering just one company can have 12-month forecasts that are on opposite ends of the spectrum? This is where dollar cost averaging comes in to save the day.
Dollar cost averaging eliminates market timing because you regularly invest regardless of the market’s highs or lows. It stops you from holding onto cash too long, waiting for a low that may never come. And it prevents you from getting caught up in a bull market frenzy and investing too much money when the market is most expensive.
As the adage goes, time in the market is better than timing the market.
You are guaranteed time in the market by using dollar cost averaging.
4. Dollar Cost Averaging Fits Your Budget
Investing can seem daunting, and many people feel you need a lot of money to reap the rewards, but that is not true. A massive benefit of dollar cost averaging is that it helps you fit investing into your budget. It meets you where you are at.
Maybe you can only squeeze out $50 or $100 per month. With dollar cost averaging, you can still take advantage of investing and the power of compounding regardless of the amount you can invest every month. Just remember to use a low-cost brokerage company like Fidelity.
You probably think, what is the point if you can do only $50 a month? It matters because compounding is so powerful.
If you are 35 years old and invest $50 per month for the next 30 years in an S&P 500 index that returns on average 10%, you will have around $100,000 by the time you retire. If you can start sooner at 25 and put that money to work for 40 years, you would have over $200,000 at retirement.
The takeaway message is that dollar cost averaging makes investing doable by making investing fit your budget.
Cons to Consider
Lump Sum Investing Might be Better
Some data suggest lump sum investing yields better returns than dollar cost averaging over the long haul. This has led some people to advocate lump sum investing over dollar cost averaging.
The argument goes that if you have a large amount of money to invest, you are better off investing it all in a short period rather than doling it out over a longer period of time. The reason is lump sum investing maximizes the time money is in the market. Over a long time horizon, it can produce superior returns to dollar cost averaging.
This makes sense, but have the people who advocate for this seen the average savings rate in the US? Sure, in theory, lump sum might be better, but most people cannot put it into practice. Most people do not have large amounts of money waiting to be invested. This is where theory meets reality.
For starters, how big does that lump sum amount have to be to have a meaningful impact years later where it would trump dollar cost averaging? Is it $5,000, $10,000, or more? And how often are you supposed to invest that amount? Then there is the problem of saving up that money in the first place.
How long would saving enough money to invest using the lump sum method take? Six months? A year? Over a year? And what are the odds an expense comes up during that time, causing you to dip into the funds before they are ever invested? All the while, you are losing time in the market, defeating the benefit of lump sum investing.
Dollar Cost Averaging Cannot Save you from Bad Investment Decisions
Dollar cost averaging or lump sum investing is only as good as the investments you select. It will not save you from bad investment decisions.
You will lose money if you put money in a highly speculative stock that goes bust. Dollar cost averaging will not protect you.
This is why investing the bulk of your investment dollars in low-cost index funds or ETFs that track the broader market is always prudent, like an S&P 500 index fund.
So please follow a sound investment strategy and build your portfolio on a solid foundation.
Only then can you truly reap the benefits of dollar cost averaging.
