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Dollar cost averaging is an investment strategy that involves investing the same amount of money at regular intervals, typically monthly. It can help reduce your exposure to certain risks, but there are also some potential downsides to consider, especially if it's your only approach.
If you're currently dollar cost averaging with your portfolio or you're considering it, here's what you should keep in mind.
What Is Dollar Cost Averaging?
Dollar cost averaging spreads out your investment in a particular stock, fund or other security over time instead of with a lump sum.
For example, let's say you're investing in a target-date fund for retirement—the fund's manager will adjust the fund's holdings over time based on your expected retirement date. With a dollar cost averaging approach, you invest $400 per month, regardless of the current share price of the fund.
Here's a quick summary of what the approach might look like over the course of six months:
| Dollar Cost Averaging in a Target-Date Fund | |||
|---|---|---|---|
| Month | Investment | Share Price | Shares Purchased |
| 1 | $400 | $40 | 10 |
| 2 | $400 | $37 | 10.81 |
| 3 | $400 | $41 | 9.76 |
| 4 | $400 | $39 | 10.26 |
| 5 | $400 | $46 | 8.7 |
| 6 | $400 | $41 | 9.76 |
Over the six-month period, you've invested $2,400. While the price of the fund fluctuated over time, including one significant jump, your average cost basis per share is $40.67, and you own 59.29 shares.
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Pros of Dollar Cost Averaging
There are some significant advantages to using dollar cost averaging, especially if you can't afford to make a lump-sum investment from the start.
Helps Reduce the Impact of Price Volatility
The stock market and other investments can experience significant price fluctuations in the short term. But if you contribute the same amount to your portfolio each month, you don't have to worry about bad timing.
If a stock or fund price increases one month, you'll buy fewer shares, and your cost per share will go up. But if it drops the next month, you'll end up with more shares and a slightly lower average cost per share.
Takes Emotion Out of the Equation
Volatility in the stock market can trigger a variety of emotions, ranging from excitement to panic.
If you're concerned about making impulsive decisions about your portfolio, dollar cost averaging eliminates that problem by putting the same amount into the investment regardless of how wildly the price swings in either direction.
Helps Build Wealth Over Time
If you're just getting started with investing or you don't have a lot of extra cash, you may wonder whether it's worth it. But you don't need a lot of money to start building wealth. In fact, many online brokers offer fractional shares of stocks and exchange-traded funds (ETFs) starting at $1.
With a dollar cost averaging approach, you decide how much you can afford to invest each month and set up automatic transfers to make the process more convenient.
Cons of Dollar Cost Averaging
While there are some clear advantages with dollar cost averaging, there are also some potential pitfalls to watch out for.
You Could Miss Out on Certain Opportunities
Investing in the same stock or fund every month could cause you to miss out on other investment opportunities. If you aren't careful, it could even result in a portfolio that isn't well-diversified.
In other words, dollar cost averaging on its own may not be enough to help you minimize your exposure to risk and accomplish your financial goals.
The Market Rises Over Time
While the market can experience a lot of volatility in the short term, it tends to rise over time. If you don't increase your monthly investment over time, you may end up with fewer and fewer shares on average.
If you can afford to make a lump-sum investment instead of dollar cost averaging, you could come out ahead if your timing is right. In the example above, for instance, you purchased 59.29 shares over a six-month period. But if you made the $2,400 investment upfront, you'd end up with 60 shares.
It Could Give You a False Sense of Security
While dollar cost averaging can be a great way to ensure that you're investing regularly, it can be easy to get complacent about your investment strategy. The right approach for you may change as the markets, economic environment and your personal financial situation fluctuate over time.
If you're not constantly evaluating and adjusting your investment strategy, your portfolio may not perform over time in the ways you need it to.
Is Dollar Cost Averaging Right for You?
As you consider whether dollar cost averaging is a good investment approach for your portfolio, here are some factors to keep in mind:
- Your ability to invest: If you have a 401(k), dollar cost averaging generally makes sense because you're investing money as you earn it. But if you have a large amount of money you can put in an individual retirement account (IRA) or brokerage account right now, you may want to consider a lump-sum investment instead.
- Your risk tolerance: If the prospect of price fluctuations stresses you out, dollar cost averaging can be a great way to reduce or eliminate the impact of emotions on your investment decisions. If you're not bothered by volatility, you may consider other investment strategies.
- Your goals: Dollar cost averaging generally only benefits you if you're holding on to your investment for the long term. If you're trading for short-term gains, dollar cost averaging may not make a lot of sense.
The Bottom Line
Dollar cost averaging can be a great way to invest for the long term, particularly for retirement. Before you engage in the strategy, however, consider both the benefits and drawbacks and research other investment strategies to find the best approach for your portfolio.
You may also consider consulting a financial advisor who can provide expert advice and personalized guidance for your situation and goals.