There’s no right or wrong way to strategize when it comes to investing. But dollar-cost averaging might be right for you—particularly if you can trust your stocks and funds to increase in value over time. Here’s what you need to know about dollar-cost averaging.
What is dollar-cost averaging?
Dollar-cost averaging is an investment strategy that involves contributing a fixed amount to a fund or stock portfolio at regular time intervals, regardless of stock prices or market movements at any given time.
When the prices of your chosen stocks or funds go up, your fixed investment will buy fewer shares. When prices go down, it nets you more shares and reduces your average cost per share over time. This way, your investment isn’t as highly impacted by volatility as it would be if you purchased all your shares in one lump sum.
This is often practiced with index funds, so that you’re dropping money into the S&P 500 or the Nasdaq Composite regardless of the price at the moment. You’re betting that markets go up over time.
Dollar-cost averaging removes the guesswork that comes with timing the market or any group of stocks and buying at the right time.
Using dollar-cost averaging
Let’s say you decide to invest $1,000 in stock ABC on the first of every month for 5 months. Assume the following table indicates how the price of the stock moves in the first 5 months.
Month
ABC stock price
Shares purchased
Shares owned
Value of investment
January
$20
50
50
$1,000
February
$18
55.55
105.55
$1,899.90
March
$21
47.62
153.17
$3,216.57
April
$19
52.63
205.8
$3,910.20
May
$22
45.45
251.25
$5,527.50
By May, a total investment of $5,000 ($1,000 X 5 months) is worth $5,527.50. Had you decided to invest that total at any one of those months, your investment might have ended up higher or lower. In this case, the average price of the stock was the same as the purchase price. But it’s lower than the stock’s highest price.
By using a dollar-cost averaging strategy, you reduced the impact of volatility in the stock price over time.
Benefits of dollar-cost averaging
Dollar-cost averaging steers you away from the risk of market timing. Because you’re investing a fixed amount at different intervals regardless of share price, you avoid emotional investing or buying more shares as prices rise and panic selling when they drop. Dollar-cost averaging keeps you on a steady, long-term investing strategy.
Dollar-cost averaging is so well-regarded, it’s used in retirement planning. If you own a RRSP, you’re already doing it. Your employer takes a fixed amount of money out of your income every payday and invests it in the stocks or funds you’ve chosen for your RRSP.
Risks of dollar-cost averaging
Succeeding in dollar-cost investing assumes stock prices will rise, at least in the long run. But prices are constantly moving, and nobody can predict with absolute certainty where prices may be heading. So, engaging a dollar-cost averaging strategy on a stock you know little about can be especially risky. You may end up buying more stocks at a time when exiting would be more suitable.
That’s why dollar-cost averaging may be more suitable for index funds or mutual funds, which invest in a variety of stocks. But in either case, it’s crucial to examine the fundamentals of any investment before employing a strategy.
Moreover, dollar-cost averaging is best used as a long-term strategy. While markets are in constant flux, prices generally don’t change much in the short term. You have to keep your dollar-cost averaging strategy in play through a long period to benefit from the low prices of a bear market and the high prices of a bull market. Either can last several months or even years.
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Automatic investing plans
Many brokers provide automatic investing plans. These strategies allow you to contribute fixed amounts of money automatically from your bank account to securities such as a mutual fund at set time intervals. Here are some popular picks.
Before you kick off your dollar-cost averaging strategy, you’ll need to open a stock trading account with a broker. Here are some of your choices.
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Bottom line
Dollar-cost averaging is the process of dividing your total investment in a stock or fund into fixed investments at set time intervals. When done correctly, this strategy can help hedge against volatility and earn strong profits in the long run. Before you invest, compare stock-trading platforms to find one that’s right for you.
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades. Read the Product Disclosure Statement (PDS) and Target Market Determination (TMD) for the product on the provider's website.
Sheri Bechtel is associate editorial director of product reviews at The Balance and a former editor at Finder, specializing in investments. Her writing and analysis has been featured in Yahoo News, Bond Buyer and Prospect News. She holds a B.A. in English from Columbus State University.
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