What is dollar-cost averaging?
Dollar-cost averaging is an investment strategy that sounds complicated, but is actually quite simple. Dollar-cost averaging means that rather than investing a lump sum of money into an asset all at once, you invest a fixed amount of money at regular intervals over a long period of time. By dividing the total amount to be invested over time, you reduce the impact of market volatility on your investment.
Your retirement plan is already doing it
If you are required to participate in a defined contribution retirement plan at work, you’re already taking advantage of dollar-cost averaging. Each pay period, regardless of how the market is performing, you are making a fixed contribution to your retirement account. Each contribution buys shares in the fund(s) your account is invested in. But while the amount of money you invest each time remains the same, the number of shares that money will buy depends upon the market value of the shares when you buy them. When the markets are up, each share will be worth more, so your contribution will buy fewer shares. On the other hand, when the markets are down, your contribution will buy more shares.
Dollar-cost averaging vs. lump sum investing
In voluntary retirement savings programs, such as a 457(b) or IRA, you get to choose how and when to invest your money. It’s not uncommon to fund these accounts with lump sum amounts, such as when you receive a year-end bonus or tax refund. But if you invest a lump sum, the entire amount of your investment is impacted by market fluctuations at once.
For example:
You receive a $6,000 tax refund and invest it in your IRA. At that time, your $6,000 buys you 600 shares at a cost of $10.00 per share. If the price of those shares goes up to $11.00 one year later, your investment would be worth $6,600 – a profit of $600. If instead, the share price falls to $9.00, you would lose $600, leaving you with only $5,400.
While you’d probably be happy with a $600 profit, you’d have to time the market perfectly to avoid losing the same amount. However, by splitting that investment up over the course of the year, you can benefit from the stabilizing effect of dollar cost averaging.
Here’s an example of how that could work:
Month |
Monthly Share Price |
Contribution |
Shares Bought |
Total Contributed |
Total Shares Owned |
Average Share Cost |
Total Account Value |
|
1 |
$10.00 |
$500 |
50.0 |
$500 |
50.0 |
$10.00 |
$500.00 |
|
2 |
$9.50 |
$500 |
52.6 |
$1,000 |
102.6 |
$9.74 |
$975.00 |
|
3 |
$9.50 |
$500 |
52.6 |
$1,500 |
155.3 |
$9.66 |
$1,475.00 |
|
4 |
$11.00 |
$500 |
45.5 |
$2,000 |
200.7 |
$9.96 |
$2,207.89 |
|
5 |
$10.50 |
$500 |
47.6 |
$2,500 |
248.3 |
$10.07 |
$2,607.54 |
|
6 |
$10.75 |
$500 |
46.5 |
$3,000 |
294.8 |
$10.17 |
$3,169.62 |
|
7 |
$10.50 |
$500 |
47.6 |
$3,500 |
342.5 |
$10.22 |
$3,595.91 |
|
8 |
$10.00 |
$500 |
50.0 |
$4,000 |
392.5 |
$10.19 |
$3,924.67 |
|
9 |
$9.75 |
$500 |
51.3 |
$4,500 |
443.7 |
$10.14 |
$4,326.56 |
|
10 |
$8.50 |
$500 |
58.8 |
$5,000 |
502.6 |
$9.95 |
$4,271.87 |
|
11 |
$8.50 |
$500 |
58.8 |
$5,500 |
561.4 |
$9.80 |
$4,771.87 |
|
12 |
$9.00 |
$500 |
55.6 |
$6,000 |
617.0 |
$9.73 |
$5,552.57 |
In this example, the share price fell below the original $10.00 purchase price for more than half the year. This allowed more shares to be purchased with each contribution made during those months. So investing the same $6,000 using dollar-cost averaging, rather than in a lump sum, resulted in a lower average share cost of just $9.73. That means instead of buying 600 shares, your $6,000 investment would have purchased a total of 617 shares.
While this example still shows a short-term loss, you’d have $152.57 more in your account than you would if you had invested your money all at once. It’s also important to remember that dollar-cost averaging is a long-term investment strategy. So while market prices are likely to experience short-term fluctuations, investing using dollar-cost averaging bought 17 more shares than a lump sum investment would have. If and when market prices rise, those 17 additional shares will help you maximize the value of your investment.
Looking back to the results of the lump sum investment vs. dollar-cost averaging examples, what would happen to the value of your investment if the share price increased to $20.00?
Lump sum investment: 600 shares x $20.00 = $12,000
Dollar-cost averaging: 617 shares x $20.00 = $12,340
Benefits of dollar-cost averaging
Dollar-cost averaging can help you position yourself to take advantage of market upswings, but it cannot prevent your investments from losing value. So whenever you’re investing, it’s important to consider your tolerance for risk. If you’re risk averse, dollar-cost averaging may help you lower your risk while providing a disciplined approach with a number of benefits:
- It removes the uncertainty of trying to time the market – i.e. “buy low and sell high”
- It takes the emotion out of investing, which is important during periods of market volatility
- It forces you to view investing as a long-term endeavor