Dollar-cost averaging is a popular strategy for building investment positions over time. When you dollar-cost average, you invest equal dollar amounts in the market at regular intervals of time. The idea is to get the best deal on a desired investment by controlling for market fluctuations. Rather than trying to time the market, you buy in at a range of different price points.
However, as with most investment strategies, there are pros and cons to dollar-cost averaging. Here's a rundown of how dollar-cost averaging works, why it can be a smart way to build a position in a stock or fund, and the arguments for and against using dollar-cost averaging. We'll also dive into whether investors are better off using dollar-cost averaging than investing a lump sum all at once, and examine all the different ways to buy stocks.
Image source: Getty Images.
What is dollar-cost averaging?
Simply put, dollar-cost averaging refers to the practice of building investment positions by investing fixed dollar amounts at equal time intervals, as opposed to simply investing a lump sum all at one time.
For example, if I want to invest $10,000 into Apple stock, instead of investing all of the money at the same time, I invest $2,000 on the first trading day of the month for the next five months, slowly building my full position.
Alternatively, dollar-cost averaging can be used to quickly build a stock position in a volatile market. For example, instead of investing $10,000 into a stock all at once, I could choose to invest $2,500 every Friday for the next four weeks.
The strategy can also be used to accumulate stock positions over a period of years. For example, I know one investor who puts $5,000 into a certain stock on the first trading day of every year and has done so for about a decade with no plans to stop or modify the strategy.
The point is that while the general idea behind dollar-cost averaging is quite simple, there are a variety of ways it can be implemented to fit specific goals or investment styles.
Putting the odds in your favor
Perhaps the biggest reason to use dollar-cost averaging is that it guarantees a mathematically favorable average price for your investment. This is easier to explain through an example, so consider this:
Let's say that you want to invest $10,000 in a certain stock, and that you choose to invest $2,000 on the first trading day of the month for five months in order to build your position through dollar-cost averaging. We'll say that on each of the five days you make a purchase, the stock is trading for $50, $40, $20, $40, and $50, respectively. In other words, the stock ended right where it started, although it was quite volatile along the way.
Here's how your five purchases would have turned out:
Price per Share
Number of Shares Purchased
Calculations by author.
Here's what I mean by a "mathematically favorable price." The average share price of this stock for the five days you made your purchases is $40 (add $50, $40, $20, $40, and $50, and divide by five), but the average price you paid ($35.71) was significantly lower.
I used round numbers to keep the calculations neat, but you can repeat this experiment using any five hypothetical share prices. Your average cost basis per share will always be less than or equal to the average of the five share prices.
Stop trying to time the market
You may be thinking: "Wouldn't it be better to have bought all of your shares when the stock was trading for $20?"
Sure it would have. It also would have been great if I could have picked last week's Powerball numbers, or if I knew whether "red" or "black" would come up next at a roulette table.
However, reliably predicting the odds of something isn't always possible. The same can be said for trying to time a stock's price. There's no way to know reliably when a stock is at its low point, or when it will go down even further. You might get lucky sometimes, but market timing is generally a losing battle.
What's more, human nature actually encourages us to do a bad job of market timing. When we see everyone else making money and a stock's price going up day after day, that's when we're most tempted to "get in on the action." And when we see everyone else panicking and selling stocks because the market is plunging, our instinct is to get out before it gets any worse. In other words, not only is market timing a bad idea, but most people are wired to get it totally wrong.
How to use dollar-cost averaging to build a stock position
The steps to executing a dollar-cost averaging strategy are simple:
Decide how much money you want to invest in a particular stock or fund.
Decide how often you want to make your investments: daily, weekly, monthly, quarterly, annually, or virtually any interval you can think of.
Decide how many periods you want to split your investments over.
Divide the total dollar amount you want to invest by the number of desired time periods to determine the amount of each investment.
There are several different outcomes from each of these steps, and each decision has its own pros and cons. There's nothing inherently better about investing monthly rather than quarterly or annually. Commissions are one thing to consider here -- if you invest too often and each investment is a relatively small dollar amount, commission fees can become rather expensive.
For example, if you choose to invest $3,000 in a stock by buying $300 each month for 10 months and pay a $7 commission per trade, those commissions represent 2.3% of your total investment. Meanwhile, if you split the $3,000 into four quarterly investments, commissions will translate to less than 1% of your invested capital.
Similarly, there are pros and cons to investing over a greater number of periods versus just a few. On the positive side, the more times you buy a stock, the better the mechanisms of dollar-cost averaging will work. In other words, if a stock becomes extremely expensive for a brief time, a smaller proportion of your shares will have been purchased at the high price if you spread your investment over more intervals. However, as I discussed above, doing so will increase your commission expense.
The point is that there are several ways to make a dollar-cost averaging strategy work for you. I've averaged into positions by buying shares once per year for a decade, and I've averaged into positions by buying shares every Monday for one month. Both can be effective, depending on your situation, but commit to your investment plan and don't skip any intervals you planned.
Pros of dollar-cost averaging
Like any investment strategy, dollar-cost averaging doesn't make sense in every financial situation. Let's take a look at some of the reasons dollar-cost averaging can be a good idea, as well as some of its disadvantages.
Here are the pros of dollar-cost averaging:
Dollar-cost averaging can be a great way to invest during volatile or uncertain markets. For example, there was a stretch in December 2018 when the Dow Jones Industrial Average fluctuated by 500 points or more every day. Dollar-cost averaging eliminates the uncertainty of "am I getting a good price?"
Dollar-cost averaging takes the emotional factors out of investment decisions. No matter how much a stock's price moves up or down between your investments, you know exactly when you're going to hit the "buy" button and how much money you're going to invest.
Dollar-cost averaging prevents unlucky market timing. Can you imagine if you had bought bank stocks in 2006 before the financial sector led a market meltdown? On the other hand, if you had been averaging into your positions, you'd have been able to buy most of your shares at cheaper post-crash prices. In fact, in a 2015 article, I showed how even though Bank of America was trading for more than 70% less than its pre-crisis peak, an investor who started averaging in a couple years before the crash would actually have been up overall.
Not everyone has a lump sum of money to invest. In other words, if the plan was to invest $10,000 in a certain stock, many people couldn't do that all at once. As we'll see in a minute, there are certainly some benefits to investing a lump sum, but that's not always an option. And when it's not, dollar-cost averaging is a smart way to build a position.
Cons of dollar-cost averaging
There's no such thing as a perfect investment strategy, and dollar-cost averaging is no exception.
Here are two important reasons why dollar-cost averaging might not be the best investment strategy:
Stocks have an upward bias over time. While prices fluctuate, the general tendency is for stocks to go higher over time. This means that if you're averaging into a position over a long time, you potentially won't do quite as well as if you had simply invested a lump sum all at once.
If you're investing in dividend stocks, there's also the argument that dollar-cost averaging into a position deprives you of income. For example, if you want to invest $10,000 into a 4%-yielding stock in $1,000 quarterly increments, during the first quarter, you'll only get dividend income on 10% of your desired investment amount. This means your first quarterly dividend check would be for just $10 (one-fourth of 4% of $1,000), not the $100 quarterly payment you'd get by investing all of your money at once.
Your 401(k) might use dollar-cost averaging already
If you have a 401(k) or a similar type of tax-advantaged retirement account at work, and you contribute to this account regularly through payroll deduction, you're already practicing dollar-cost averaging.
Think of it this way: You earn, say, $60,000 per year and contribute 5% of your salary to your 401(k) and your employer matches your contributions dollar-for-dollar. This means that $6,000 is flowing into your account over the course of the year. However, it's not a lump sum -- some of this gets deposited every time you get paid. If you get paid bi-weekly, for instance, this means that you're investing about $231 every other week into your chosen allocation of investment funds. With this equal amount of money, you're buying more shares of each investment fund when the price is lower and fewer shares when they're more expensive.
Put another way, buying stocks using dollar-cost averaging is applying your 401(k) strategy to your stock portfolio. You're not trying to time the market -- you're simply investing a little bit over time to try to build your account's value. And dollar-cost averaging lets you do it on a mathematically favorable basis.
Does investing a lump sum produce superior results?
There's a classic debate about which strategy is more profitable: investing a lump sum at once or dollar-cost averaging into your stock positions.
And there's some pretty compelling research that points in favor of the all-at-once approach. Vanguard did a study that compared historical investing strategies in three markets -- the United States, the U.K., and Australia -- using rolling historical periods. Using a 60% stock, 40% bond portfolio, the study compared immediate investing of a lump sum with splitting the same investment over monthly installments.
Over 12-month periods, the lump-sum strategy outperformed dollar-cost averaging 68% of the time in U.S. markets, and by an average margin of 2.39%. The study found that the lump-sum strategy was usually the better way. And it was more advantageous over longer time periods. For example, in six-month intervals, the immediate investment strategy was the better result 64% of the time. When the historical intervals were stretched to 36 months, the immediate investment strategy was the winner 92% of the time.
Why is the lump-sum strategy so successful? Two reasons. Stocks have an inherent upward bias over time, for one. So, theoretically, the stock component of a portfolio will be cheaper now than it is a year from now.
Even worse is the effect known as "cash drag." That is, in the early stages of dollar-cost averaging, a large amount of money is sitting on the sidelines in cash, earning minimal returns. For example, if you're splitting a $12,000 investment over 12 monthly installments in a 60% stock, 40% bond portfolio, after six months, your portfolio allocation is really 30% stock, 20% bond, and 50% cash. That cash component weighs on returns, and the effect is a particularly large drag over longer intervals.
With all of that in mind, there's one big caveat to keep in mind when digesting the results of that study. Not everyone has a lump sum of cash sitting on the sidelines.
In other words, if you want to build a $30,000 position in a stock, would it be practical to do it tomorrow? For the majority of investors, the answer would be no.
The bottom line: Yes, if you have a lump sum of cash to invest, portfolio theory says that you'd be better off investing the entire amount immediately, rather than formulating a dollar-cost averaging strategy. However, if you don't have a lump sum of cash to invest right away, this argument is quite meaningless to you, as buying an entire position immediately simply isn't an option.
Is dollar-cost averaging right for you?
In a nutshell, there are four possible ways to buy a stock:
Invest a lump sum of money all at once. This can certainly be a good idea from a long-term perspective if you have the cash available.
Dollar-cost average into positions by investing equal amounts of money at set intervals.
Buy an equal number of shares at set intervals. There can be good reasons to use this approach as well, such as to execute certain options strategies (options contracts are typically for 100 shares).
Simply invest in the stocks you like whenever you want. To be honest, this is what I typically do these days, but I've been an investor for a while, and I evaluate stocks for a living. For beginners, I strongly recommend having a plan, mostly to take emotion out of the equation.
To be clear, all four of these methods can work in certain circumstances, and I've used all of them at one time or another (although I'd suggest the final way only to more experienced investors).
However, in a volatile or uncertain market environment, when you don't have a lump sum of cash to invest, or if you're worried that stocks might be too expensive, dollar-cost averaging can certainly be a smart investment strategy.
More From The Motley Fool
Matthew Frankel, CFP owns shares of Apple and Bank of America. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.