Dollar-Cost Averaging: A Beginner's Guide to Strategic Investing

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Dollar-cost averaging is a useful way to help build wealth. The point of this long-standing technique is to help you remove the emotion from investing to better withstand the volatility in the stock market. 

Whether you’re a novice investor or someone who has been dabbling in the stock market for a while, it’s beneficial to understand what dollar-cost average investing is and how it can apply to your financial situation.

What Is Dollar-Cost Averaging?

Dollar-cost averaging (DCA) is a strategy investors use to minimize the effects of volatility in the market. Investors using a DCA strategy evenly distribute their total investment at regular intervals and equal amounts, which helps them avoid investing their entire purchase before a declining market.

In other words, dollar-cost averaging means that the investor purchases securities in smaller amounts over a period of time instead of investing it in one lump sum. It’s best used when you’re looking for a successful long-term investment strategy or during bear markets, where you can purchase assets at lower prices when others may be too afraid to buy, helping you score the best deals.

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How Dollar-Cost Average Investing Works

One of the most common investment vehicles for dollar-cost average investing is with employer-sponsored plans, the most common being 401(k) plans. Here, the employee elects a set amount of money to be deducted from their paycheck to go toward their 401(k) account. The investor decides how much and how often to invest, then makes sure that plan is consistent.

For an investor to start dollar-cost averaging, they’ll need to determine how much to invest, types of investment vehicles that are appropriate, and at what intervals.

Let’s break this down further:

• Figure out how much to invest: Determining the amount is up to you, but make sure that you can afford the amount. Be certain your budget will give you wiggle room to pay your bills and tackle short-term goals.
• Figure out where you invest: Dollar-cost averaging works best when it’s being used in long-term investment vehicles. That means your money should remain in accounts for at least 5 years, though ideally 10 or more.
• Figure how often to invest: There’s no wrong answer. You can invest weekly, monthly or quarterly. To help make it easier, consider setting up automatic transfers to your brokerage account.

Dollar-Cost Averaging Examples

Although dollar-cost averaging is a simple concept to understand, it’s helpful to look at it in comparison to other investment strategies such as lump-sum investing to see how it really works.

Let’s say you have $30,000 you want to invest in the stock market. You decide to invest in an exchange-traded fund, or ETF. However, you’re not sure whether to invest all $30,000 as a lump sum now, or spread it out in equal amounts each quarter over the next 2 years.

Now, let’s compare both strategies to see whether there’s a major difference.

Lump-Sum Investing

Here, you put in $30,000 all at once at the beginning of the month and will not purchase additional shares for the next six quarters. You end up purchasing 240 shares, with an average share price of $125.

Investment Period	Amount Invested	Share Price	Number of Shares Purchased
Quarter 1	$30,000	$125	240
Quarter 2	$0	$50	0
Quarter 3	$0	$40	0
Quarter 4	$0	$25	0
Quarter 5	$0	$40	0
Quarter 6	$0	$20	0
	Overall Purchase	Average Share Price	Total Shares Owned
	$30,000	$125	240

DCA Investing

For DCA investing, you spread out your $30,000 investment over six quarters at $5,000 each. As the share prices fluctuate, so will the amount of shares your purchase. Here, you end up having a larger number of shares, but with a lower average price. What this means is that you could potentially earn more on your investment when the share price rises. Or, you’ll only need to sell your shares at $80 to break even, whereas with the lump sum investing scenario, that number would be $125.

Investment Period	Amount Invested	Share Price	Number of Shares Purchased
Quarter 1	$5,000	$125	40
Quarter 2	$5,000	$50	100
Quarter 3	$5,000	$40	125
Quarter 4	$5,000	$25	200
Quarter 5	$5,000	$40	125
Quarter 6	$5,000	$20	250
	Overall Purchase	Average Share Price	Total Shares Owned
	$30,000	$50	840

The Benefits Of Dollar-Cost Average Investing

The three main benefits to dollar-cost averaging are that it can help you remove the emotion from investing in general, be able to think more long-term, and avoid mistiming in the market. Think about it: If you see the swings in the market, you’re more likely to make investment decisions that are more based on emotions. For instance, you might switch between fear (where you’re worried the market will drop) to greed (purchasing more shares because you think you’re getting a deal).

Using dollar-cost averaging will mean that you’re still investing without timing the market, instead of using “instinct” to make smarter purchases. In essence, it helps you to see that the market will go up over time despite the swings, helping you look at investments as a long-term endeavor.

It simplifies the investment process for those new to stocks, bonds, ETFs and mutual funds. Instead of worrying about the best time to invest, you only need to worry about how much and where to invest.

The Drawbacks Of Dollar-Cost Average Investing

There are some potential drawbacks that investors could experience when they use the DCA strategy to navigate the stock market. For one, there could be additional trading costs since you’ll be investing more frequently compared to lump sum investing. However, there are many brokerages that are charging less, with some foregoing fees on certain types of investments.

The second downside is that you may be risking (or even giving up) any gains that you may have earned if you had invested using lump-sum investing when stock prices went up. That being said, the chances of you timing the market are slim — even experienced investors aren’t great at predicting how the stock market will move in the short term.

The Bottom Line

Dollar-cost averaging is a great way for investors to remove the emotions associated with investing. It’s a simple strategy that can help you look toward the long term, such as your retirement goals. Those interested in learning more about investing and how it can help improve your financial health can visit the Rocket HQ℠ Personal Finance Learning Center.