What is dollar-cost averaging?

Dollar-cost averaging is a popular long-term investment strategy that can help investors mitigate risk by turning the market’s natural ups and downs to their advantage. It works by automatically investing the same amount at regular intervals—weekly, monthly, etc.—regardless of share price. This way, more shares are purchased when prices are low, and fewer when they’re high.

Dollar-cost averaging is one of the most popular ways to invest and build wealth for the long term.

Chances are, you may be using it right now without even realizing it. Contributions to retirement accounts such as 401(ks) are made using dollar-cost averaging. Think back to when you first set up your account.

You simply needed to:

1. Enroll in the 401(k)-plan offered by your employer
2. Determine how much you want to contribute each pay period

That’s all that dollar-cost averaging is: regularly scheduled contributions of a fixed amount, made automatically at a predetermined interval. For 401(k)s, the interval is every pay period. This gradual approach to investing makes dollar-cost averaging a formidable strategy for investors who want to reduce risk.

How does dollar-cost averaging work?

Think of dollar-cost averaging like wading into a pool, as opposed to just diving in. Instead of investing a lump sum all at once, investments are made incrementally with the same amount at regular intervals on a fixed and automatic schedule.

For example, let's say you have $6,000 to invest. You can invest it all right away in one lump sum and hope you timed the market right. If the fund goes up, congratulations! But if you timed it wrong and bought your shares at the top of the market, you could see substantial losses after even just the slightest market downturn.

On the other hand, by using dollar-cost averaging, you could invest a smaller amount in regular intervals, say $1,500 per month over a four-month period. As shown in the table below, the number of shares purchased each month will vary depending on the price at the time of purchase.

The only thing consistent about markets is that they’re always changing. Price fluctuations happen all the time, in every sector, every single day. That’s why trying to “time the market” is practically impossible. The truth is, nobody knows what will happen in any given time period. That’s why the regularity of dollar-cost averaging is important, because it removes the psychological barriers that may cause many investors to hesitate and try to “time the market,” which can lead to extended inaction, missed opportunity, and needless stress over volatility.

What are the benefits of dollar-cost averaging?

Dollar-cost averaging is a widespread strategy for investors to get in the market for the long term. There are many benefits to this style of investing, including:

1. Ease—Dollar-cost averaging requires no particular knowledge of the market, and it takes just minutes to set up with free automatic investing services offered by many financial institutions.
2. Used for long-term goals—This style of investing is a good fit for building savings and wealth over the long term because gradual investing helps reduce the impact of day-to-day price fluctuations.
3. Encourages action—By automatically investing at set intervals, it eliminates the tendency for investors to hesitate on the sidelines, waiting for the right time to invest.
4. Accounts for volatility—Because investments are made over time at various prices per share, the strategy is particularly suited for riding the typical ups and downs of the market.

As we know, it is challenging to time the market. However, with dollar-cost averaging, any investor has the opportunity to slowly but surely build wealth for the long term, without agonizing over day-to-day market fluctuations.

What are the downsides of dollar-cost averaging?

There has always been a spirited debate about the upside of dollar-cost averaging vs. investing everything at once, a strategy known as “lump sum” investing. You can think of lump sum investing as diving into a pool, instead of wading in slowly.

Every investment strategy comes with risk. Though dollar-cost averaging helps to mitigate many of market risks, there is no such thing as a “silver bullet” approach to investing. Risk can be minimized, but never avoided entirely. With that in mind, it’s important to know why many proponents of lump sum investing choose to avoid the incremental approach of dollar-cost averaging:

1. Cash drag—Historically, uninvested funds (cash) have a tendency to underperform compared to money in the market. In a rising market, investors can possibly miss out on positive returns when leaving more of their money in cash, an effect known as “cash drag.”
2. Missed opportunities—By only investing small amounts at a time, investors can miss out on positive returns in a rising market.
3. Delaying risk—Some believe that dollar-cost averaging does not truly reduce market risk, it simply slows it down.
4. Fees—Dollar-cost averaging can result in a larger number of smaller purchases, resulting in more trade fees.

Dollar-cost averaging vs. lump sum investing

To dive, or to wade? That is the big question when deciding whether to invest all at once in one lump sum, or over time using dollar-cost averaging. It’s a debate that has been going on for years among investors.

Here’s a comparison example using the same $6,000 investment from earlier:

Let’s say you made a lump sum investment and invested all $6,000 in $25 shares in January. Over the course of four months, your investments would face the markets ups and downs throughout the year, landing you with an even $6,000. No gains, no losses.

Now what if you used dollar-cost averaging and spread out your investments at regular time periods? In some months, the cost of a share would be less than $25. Sometimes it would be more. But at the end of the four months, you would have made a profit of $335 just by spreading your money out.

When making the decision, it’s important to understand the tradeoffs. Lump sum investing can get you into the market faster, but it could also expose you to more risk. On the other hand, dollar-cost averaging could help protect you against market volatility, but in a bull market it could also limit your upside.

In a volatile market where concerns about short-term drops are paramount, dollar-cost averaging is often the preferred approach because it spreads out risk over time and protects investors from investing too much at the top of the market.

In periods of economic growth and market gains, lump sum investing has generally outperformed dollar-cost averaging. But investors who choose that route should be aware of the risks. Short-term market movements can be unpredictable, which means investors could be buying at the top of the market.

From regular brokerage accounts to retirement accounts like 401(k)s, IRAs, and more, dollar-cost averaging is one of the most widespread ways for investors to break into the market. It’s a more gradual approach that helps investors guard against never buying too much at too high of a price. If you’re looking for a way to get into the market for the long term, dollar-cost averaging may be the right approach for you.