Learning how to invest skillfully and committing to studying the markets can be challenging. But you don’t have to be a shrewd, eagle-eyed trader to benefit from investing. Whether you are in the early stages of your wealth-building journey or a seasoned investor who prefers a simple and practical approach, you may want to consider dollar cost averaging.
You may already be utilizing dollar cost averaging as a strategy without even knowing it. But learning more about dollar cost averaging and how it works can help you become a savvier investor.
What Is Dollar Cost Averaging?
Dollar cost averaging is a time-tested strategy to help reduce the impact of market volatility. It consists of investing a fixed dollar amount at regular intervals — regardless of share price. Instead of aiming to buy stocks or funds at a particular price point at the most opportune time, those using dollar cost averaging purchase securities in smaller amounts over time.
The idea is to increase the likelihood of paying a lower overall price per share by dividing up your purchases as the market fluctuates.
Not only does dollar cost averaging mitigate the inefficiencies, emotions, and financial costs involved in attempting to time the market, but it also sets one of the cornerstones of long-term investment growth into practice: putting your money to work in a disciplined, consistent way.
Dollar Cost Averaging in Action
Let’s say you commit to investing $500 monthly, regardless of whether the market is up or down. Although your $500 will buy fewer shares when the market is up, it will buy more shares when it is down. Dollar cost averaging recognizes that, over time, you could potentially lower your average cost per share, as opposed to what you would have paid if you bought every share at once.
For example, in month one, you buy 100 shares at $5 per share. In month two, you buy 250 shares at $2 per share. And in month three, you buy 125 shares at $4 per share. At the end of three months, you would have bought 475 shares and paid an average of $3.16 per share. In theory, you could’ve paid as much as $5 per share if you’d purchased them in a lump sum in month one, or if the market went back up in month four.
In a perfect world, you would have purchased all of your shares in month two at $2 per share, but that would require predicting and timing the market. Dollar cost averaging taps into the investing wisdom that buying regularly and frequently over the long term makes you less likely to miss favorable buying opportunities.
One of the most common examples of dollar cost averaging in practice can be found in 401(k) plans. A set amount of money comes out of your paycheck each month and is automatically invested for you. You may have also put it into practice with a personal IRA, a mutual fund, an index fund through your bank or investment firm, or even through a micro-investing app such as Acorns.
Does Dollar Cost Averaging Really Work?
No investment strategy can assure positive results, but history shows that trying to time the market often leads to losses for investors. Predicting the ideal moment to invest is challenging, and hesitation can result in missed opportunities for profit. Dollar cost averaging allows you to be invested at various price points, reducing the risk associated with investing a large sum at one specific point in time.
It’s important to note that this should not be your only strategy. Relying solely on dollar cost averaging could cause you to miss out on certain investment opportunities. You’ll also want to consider a well-diversified portfolio. And if you’re not careful to regularly assess and increase the dollar amount you’re investing, it may ultimately result in fewer shares purchased over time. Don’t allow it to give you a false sense of security.
Benefits of Dollar Cost Averaging
While the potential to reduce the cost per share is significant, dollar cost averaging also helps investors by tempering emotional reactions tied to fear and greed — their own and those of other investors. The consistent approach prevents the pitfalls of attempting to time the market, which is notoriously difficult even for professionals. It encourages a long-term perspective, enabling you to view market downturns as potential opportunities rather than threats.
This strategy also establishes sound investing habits by encouraging discipline and adherence to financial planning goals. It helps avoid the impact of regret and loss aversion by spreading investments over time, making it easier for investors to weather poorly timed trades. And it reduces anchoring bias—the tendency to rely heavily on the first piece of information received (like an initial stock price) when making decisions. This reduction enables more flexible decision-making based on a pre-established plan rather than being swayed by emotional attachment to past market highs.
Who Is Dollar Cost Averaging for?
Dollar cost averaging is an effective strategy for investors starting out with smaller amounts as well as those regularly contributing to retirement accounts like IRAs and 401(k)s, reinforcing a disciplined investment approach. Long-term investors benefit from its potential for compounded growth over time, while busy professionals appreciate the minimal monitoring required. Risk-averse individuals find comfort in its ability to help address market volatility. Parents saving for education and freelancers with fluctuating incomes can also leverage this strategy to invest consistently according to their changing financial situations.
On the other hand, dollar cost averaging may not be a good fit if you have a substantial sum to invest; you might miss out on potential immediate gains. If you’re investing in mutual funds with higher initial investment requirements through a taxable brokerage account, other strategies may be more cost-effective. If you enjoy investment research and are willing to dedicate extra time and effort to it, you may find alternative strategies more appealing. And if you have short-term investment goals, where timing is a critical factor, you’ll want to consider a different approach.
To optimize your dollar cost averaging strategy, we recommend consulting with a financial advisory firm like Stoddard Financial. Their expertise can provide tailored guidance and help you navigate market complexities.
Kevin Stoddard is a LPL Financial Advisor with Stoddard Financial in Medfield, Massachusetts. Stoddard helps clients throughout New England to identify, plan, and execute strategies designed for securing their desired financial future. With their Financial Wellness @ Work program, they engage, educate, and empower employees by helping them to understand and appreciate the value of their benefits package.
Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate and is intended merely for educational purposes, not as advice.