If you’ve followed the market for any length of time, you know the share prices of investments can fluctuate wildly. This can make it difficult to decide when to invest, especially for new investors. Fortunately, there’s something that might help simplify things: dollar-cost averaging (DCA).
Here’s a closer look at how dollar-cost averaging works and how to tell if it’s the right investment strategy for you.
What Is the Concept of Dollar-Cost Averaging?
When you think of investing money, you might imagine using a lump sum to buy shares of a particular stock. Dollar-cost averaging works a little differently. DCA is an investment strategy where you invest a specific amount at fixed intervals.
For example, imagine that you have $1,200. You could invest the entire amount at once. However, if you’d rather use dollar-cost averaging, you might invest $100 every month for 12 months.
Why Should You Use Dollar-Cost Averaging?
With DCA, you can reduce the impact of market volatility on your returns. When you invest small amounts over time, you buy some shares at high prices and others at low prices. As a result, the cost per share averages out over time.
How to Use Dollar-Cost Averaging
Dollar-cost averaging (DCA) is simple to implement once you have a plan in place. Here’s how to get started:
- Choose your investment wisely: Start by identifying a fund or asset you believe in for the long term—such as a broad-market index fund, ETF, or retirement account. DCA works best with investments designed to grow steadily over many years, not short-term trades.
- Decide on your contribution amount: Pick a fixed dollar amount that fits comfortably within your budget. It could be $50 or $500 per month—the key is consistency. Regular contributions make it easier to build wealth gradually without trying to time the market.
- Set a recurring schedule: Automate your investments on a set timeline, such as every two weeks or once a month. This takes emotion out of the process and ensures you’re buying shares at different prices over time, averaging out your overall cost.
- Stay consistent and review periodically: Stick with your schedule through market ups and downs. Over time, you’ll buy more shares when prices are low and fewer when prices are high. Review your plan once or twice a year to make sure it still aligns with your goals and risk tolerance.
When Should You Use the Dollar-Cost Averaging Strategy?
You can apply the concept of dollar-cost averaging to almost any kind of investment. However, the best investments for dollar-cost averaging are typically exchange-traded funds (ETFs).
An ETF is a fund that includes a variety of investments like commodities (physical goods such as gold, oil, or agricultural products that are traded on the market), stocks, and bonds. When you buy shares in an ETF, your investment is diversified across all of these assets. That way, if an individual sector or company experiences financial turbulence, the impact on your portfolio will be minimal.
When Not to Use Dollar-Cost Averaging
You can use DCA when investing in individual stocks, but it’s a lot riskier. When your investment hinges on a single company’s performance, you’re more likely to lose money.
Notably, if you have an employer-sponsored retirement plan like a 401(k) and make contributions from each paycheck, you’re already automating investments with dollar-cost averaging.
What Are the Three Benefits of Dollar-Cost Averaging?
Is DCA good for beginners? In many cases, the answer is yes. Here are three benefits of dollar-cost averaging that are especially helpful for beginners:
1. You Don’t Risk Mistiming the Market
Buying investments at low prices and selling at high prices generates maximum profits. Many investors will try to “time the market,” meaning they attempt to predict the best times to buy and sell.
With experience, it’s possible to develop a kind of intuition about what the market will do next. However, even the most talented investor can’t see into the future, and if you wait for the perfect time to invest, you’ll probably miss out on some solid opportunities.
If you’re new to investing, you likely don’t have a good sense of market timing. When you learn how to reduce risk with dollar-cost averaging, you don’t have to worry about timing at all. Instead of trying to correctly time a single investment, DCA lets you make multiple small investments at regular intervals.
2. It Builds Consistency
If you want to achieve some level of success as an investor, it’s important to build discipline. Long-term dollar-cost averaging can help you get into the habit of consistent investment. Making small investments on a schedule (as opposed to infrequent large investments) also makes it easier to grow your portfolio over time.
3. It Takes Emotion Out of Investing
In theory, investment decisions are based on logic, research, and experience. However, the truth is that it’s easy to get carried away by emotion.
For example, if a particular stock is rapidly falling in value, an investor might panic and sell it as fast as possible. They might think that they’re limiting their losses. However, by selling, they’re making an unrealized loss into a permanent one.
Many investors learn to keep their emotions in check over time. However, when you use dollar-cost averaging and stick to your investment schedule, you can take emotion out of the equation entirely.
Potential Downsides to Consider
As investment strategies go, dollar-cost averaging is generally considered safe. However, that doesn’t mean it’s perfect. There are some potential disadvantages to consider, including:
- Making many small transactions may mean paying more in brokerage fees
- In bull (rising) markets, DCA is less profitable than lump-sum investing
- Although DCA minimizes risk, it’s also less likely to result in large returns
Dollar-cost averaging in a volatile market can protect you from losses. But in a stable market where values are rising, relying mostly or entirely on DCA may limit your returns.
When looking at the risks and benefits of dollar-cost averaging vs. lump-sum investing, you might discover that many investors find lump-sum investing to be more profitable over time. That may be true in some cases, but lump-sum investing often carries higher risks, especially if you’re a new investor.
If you’re drawn to the potential profits of lump-sum investment but are concerned about risk, consider starting with dollar-cost averaging. As you gain experience and study the market, you’ll build the confidence to make lump-sum investments as well.
The Importance of Formulating a Personalized Investment Strategy
Is dollar-cost averaging a good idea? It can be, especially if you’re new to investing. However, no investment strategy is flawless.
As you gain experience as an investor and take the time to learn about different strategies, you’ll have a better sense of your long-term investment goals and how the dollar-cost averaging strategy fits into them.
