How to use dollar-cost averaging

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5 Minutes Read

A "hack" to take the emotion out of investing.

Investing can be intimidating. Timing the market is hard, especially when you’re a beginner. How do you know the right time to buy and sell a stock? Plus, investing a large amount of money up front can put a strain on your finances. And what’s all this talk you hear about psychological biases?  

Dollar-cost averaging is an investment strategy that takes some of the pressure off. In this blog, we’ll help you decide if dollar-cost averaging is right for you by showing you how it works in different market conditions and laying out the pros and cons. 

Let’s jump right into it!

 

 

What is dollar-cost averaging?

Dollar-cost averaging means breaking up one investment into smaller, consistent investments spread out over time. Instead of purchasing a lot of shares at once, you buy smaller amounts of shares at regular intervals, regardless of price.

The amount of money you invest stays the same every time, but the number of shares you can buy will change as the market changes (thanks fractional investing!). Buying shares at a range of different prices – instead of timing the market – will ideally result in a lower average price per share over time. 

The basic idea is to build wealth over the long term and minimize the impact of the ups and downs in the market (a.k.a. market volatility).

Dollar-cost averaging can be powerful during recessions and bear markets because low prices mean you’re able to purchase more shares. Since dollar-cost averaging is a long-term investment strategy, the prevailing theory is that shares bought low will have time to grow in value as the market trends upward. (Stay tuned for an example of how this works!) 

This strategy can also prevent emotion from undermining your portfolio, so you can invest in down markets with much less stress. For example, you’d probably feel more regret about a poorly-timed trade if you invested a large amount of money at once rather than just a little. Also, by sticking to your regular investment intervals, the question of when to buy shares is removed from the equation.

 

 

Dollar-cost averaging can also help with anchoring bias — something that happens when an investor gets overly attached to a specific number or value for their investment. (For example, you bought a stock for $200 and even though the value has now dropped below that, you’re still reluctant to sell because you’ve become anchored at $200). An investor is less likely to cling to a specific price anchor using dollar-cost averaging because when they’re buying shares in regular intervals, the price doesn’t matter.

By the way, you can use dollar-cost averaging to invest in mutual and index funds as well. This tactic can help diversify your portfolio, reducing risk (check out this blog for the full rundown on how it all works). If you decide to go the fund route, try to choose one with no or very low transaction fees! 

 

How does it work?

Dollar-cost averaging works because over the long term, stock prices tend to rise, even if they move up and down in the short term. This strategy is most effective when the stock market is  fluctuating throughout the time period you’ve chosen to invest for. If stock prices rise continuously, an investor using dollar-cost averaging would end up buying less shares because their investment doesn’t go as far when prices are higher. 

Let’s look at a few examples to see how well dollar-cost averaging works in different markets.

Say you want to invest $1,200 in Company XYZ within the next 6 months. You basically have two choices: invest it all now or invest $200 every month for the next 6 months.

Currently, shares of Company XYZ are trading at $20/share. So with a lump sum strategy, you would invest your $1,200 at $20/share and receive 60 shares. 

 

Example 1: A declining market

Assume the $1,200 is split equally into 6 $200 purchases. Over the months you plan to invest, the share price changes and therefore so does the amount of shares purchased.

 

 

As you can see, for the same $1,200 you can get way more shares (97.56 vs 60) for a lot less ($14/share vs $20/share) by using dollar-cost averaging instead of lump sum investing in a declining market.

This is why dollar-cost averaging works so well in a bear market — as the price per share decreases, you’re able to buy more shares with the same fixed investment amount and then later sell them for a higher profit when (or if) prices rise again.

 

Example 2: A sideways market

Again, assume the $1,200 is split equally into 6 $200 purchases but the market in this scenario is sideways — the share price rises and falls within a range but doesn’t indicate a clear upward or downward trend.

 

 

Whether you lump sum invest or use dollar-cost averaging, the outcome looks pretty similar in this scenario. However, don’t forget that there are other benefits of dollar-cost averaging, like reducing risk. By using dollar-cost averaging during a sideways market, you’ve eliminated the risk of incorrectly timing the market — and at no cost (in fact, you actually get an extra 1.28 shares out of it).

 

Example 3: A rising market

Same terms, prices are now rising.

 

 

Dollar-cost averaging seems weaker here, since your average price per share is much higher and the number of shares purchased is much lower than what you could get if you just invested $1,200 today. In the short term, dollar-cost averaging isn’t a very effective strategy in a rising market. If you want to use dollar-cost averaging in these conditions, you could try spreading your purchases out more to try catching a dip in price.

In reality, this type of scenario is rare because stocks are volatile — even the most stable stocks tend to fluctuate. 

 

Dollar-cost averaging in theory vs. reality

 

 

Of course, in real life dollar-cost averaging doesn’t play out as perfectly as it does in our hypothetical examples. Research has also shown that over the very long term (about 65 years), dollar-cost averaging can underperform lump sum investing — but not by much and not every time. Dollar-cost averaging beat lump sum investing about a third of the time.

The thing is, not everyone has large sums of money to invest right away — and waiting until you do have enough means you’re missing your chance to get started sooner. Investing a lot of money at once can also be very stressful, so dollar-cost averaging could help ease things psychologically.

 

Who should use dollar-cost averaging?

 

While dollar-cost averaging can be a very effective investing strategy for all types of investors, it’s not for everyone. You might consider dollar-cost averaging if you:

  • Are a beginner investor without a lot of experience or expertise
  • Don’t have a large sum of money to invest right away
  • Are prone to emotional investing or want to take some of the stress out of investing
  • Aren’t interested in doing the research and monitoring involved in timing the market
  • Want to regularly invest for the long term
  • Are unlikely to invest in down markets

Remember, dollar-cost averaging isn’t appropriate for all situations so it’s best to do your research before trying it — just like with any investment!

 

Pros and cons of dollar-cost averaging

 

Pros

Cons

Final thoughts

 

 

There’s more than one way to invest! Everyone has different goals, experience, and tolerance for risk — what works for someone else might not work for you. Timing the market is a very popular strategy, but it’s also a risky one. If you’re looking for a less stressful approach that doesn’t require a lot of effort, dollar-cost investing might be the way to go.

Melissa Atefi

Author