Dollar-cost averaging is a popular strategy investors use to make regular investments regardless of the state of the market. Doing this means you buy fewer shares when the stock price is high and more shares when the stock price is low. This strategy works well for smaller investors who don't have a large sum of money to invest all at once.
Let's dive into what the dollar cost averaging approach is and the reasons why investors use it to build wealth over the long term.
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- Dollar-cost averaging involves consistently investing the same amount of money over a period of time regardless of the price of securities.
- The purchase price of security averages out, reducing the impact of price volatility on an investor’s portfolio
- This strategy eliminates the need for market timing and reduces emotional decision-making.
- Since it's impossible to predict what the market is going to do in the future, it is often the best bet.
What is dollar cost averaging?
Dollar-cost averaging is an investment strategy where you consistently invest in the market regardless of whether the market is up or down. Over time the cost of each share you add to your portfolio averages out, mitigating some risks that come with price volatility.
Investors who use this investing strategy put the same amount of money in a stock, bond, or other security over time. It reduces the need to actively manage their portfolio or think about market timing to get shares at the best value.
Dollar-cost averaging is a useful strategy to remove emotions from investing. Some investors make decisions based on their emotions, which can adversely impact the long-term growth of their portfolio.
Related: How to start investing
Benefits of dollar cost averaging
There are several reasons that this is a popular investing strategy. Here are some of the biggest benefits of this strategy:
Make regular investments
The biggest benefit of dollar cost averaging is that you're investing regularly and it puts your money to work consistently. Rather than waiting to invest a large sum of money when the market is just right, you spread your investment out at regular intervals over a longer period of time. This gets your money invested sooner rather than later, increasing opportunities to purchase more shares at lower prices and increase your overall gains.
Build strong habits
The practice of consistently investing your money establishes a strong, disciplined habit that will lead to long-term wealth building. Waiting to time the market means money is available for other expenses that come up. Dollar-cost averaging eliminates the temptation to spend it by investing it as soon as possible. Not to mention, it makes it easier to get started, even if you only have $5 or $10 in your budget to invest with.
Capture market fluctuations
As you make more investments and grow your portfolio, dollar cost increases opportunities to capture market fluctuations. When the market is up that means you could use some of the gains to reallocate your portfolio into other assets, enhancing your returns.
Avoid emotional decisions
Dollar-cost averaging removes you from the equation. You don’t have to worry about making decisions based on your emotions. While staying informed about the market is important, you don’t have to time it to get the best return on your initial investment. This can help mitigate some of the risks that come with market downturns.
Drawbacks of dollar cost averaging
Dollar-cost averaging is great for individuals who are trying to establish a new investing habit or want to invest small amounts of money over a period of time. There are some circumstances, however, where it might not be the best option.
Not ideal for a lump sum
If you have a large sum of money — such as a bonus or an inheritance — it’s better to invest that money sooner rather than later. This way you can start generating a return from it immediately.
Hard to reach fund minimum
Dollar-cost averaging is great for purchasing individual stocks, bonds, and exchange-traded funds (ETFs) but it doesn’t work well for all securities. If you prefer to invest in a mutual fund, for example, you’ll need to invest a lump sum upfront because there is usually a minimum investment requirement you’ll have to reach first.
Miss short-term opportunities
Depending on your risk tolerance, dollar cost averaging can reduce your opportunities to capture sudden changes in the market. Someone who regularly invests in an ETF that tracks the S&P 500 is well-suited for long-term growth but they miss out on opportunities to gain from emerging events like geopolitical developments, initial public offerings from promising tech companies, and other short-term trends.
Easy to forget
For investors who want to set and forget their investments, dollar cost averaging can be a double-edged sword. While it makes it easy to make consistent investments, it also makes it easy to forget about your portfolio. If you regularly check in and rebalance your portfolio you could find yourself exposed to risks you hadn’t anticipated, affecting your long-term returns.
Examples of how dollar cost averaging works
While dollar cost averaging is an easy way to consistently invest, it can impact your portfolio differently depending on the state of the market. These are a few different examples to consider when implementing this strategy.
When the market rises
When the market rises, the value of stocks rises too. While this is a good thing for someone who already owns stock, that’s not the case for someone who’s buying stock. Your investment will purchase fewer shares, which can reduce the overall value of your portfolio in the long term compared to investing in a lump sum.
When the market falls
Dollar-cost averaging is a good strategy to use in declining markets as this means stocks have gone on sale. Because the average purchase price is lower, you can buy more. When the market goes back up, you have more shares in your portfolio to capture gains from. It makes this possible without worrying about timing the market just right.
When the market is flat
When the market is neither rising nor falling you can still benefit from dollar cost averaging. The amount of shares you’d be able to purchase is comparable to investing a lump sum of money all at once. The difference with this is that you don’t have to worry about timing the market. You’re still able to add shares to your portfolio and be prepared to generate a return when the market eventually goes back up.
Can you do dollar cost averaging with the S&P 500?
Following the S&P 500 is one of the easiest ways to implement a dollar-cost averaging strategy. You can regularly purchase shares of an ETF that tracks the S&P 500 to grow your portfolio. While there are some fees involved with ETFs, it eliminates the pressure of picking individual stocks and allows you to capture gains from a variety of companies in the economy.
Is it better to dollar cost average or lump sum?
The investment strategy you opt for will largely depend on your personal preferences and circumstances.
If you already have a lump sum of money to invest, then it might make sense to invest it all at once. This puts your money to work sooner rather than later.
Dollar-cost averaging is better if you don’t already invest consistently and want to get started. It eliminates some of the decision-making that goes into investing and distributes risk over a longer period of time.