Investors face two key questions about the stock market: When to get in and when to get out?
The answers to both: Almost no one knows, and for individual investors, trying to time an optimal entry and exit is generally a losing effort. Even market professionals often get it wrong in trying to buy low and sell high. Part of the problem is that stock markets are erratic in the short term; it’s impossible to predict how the markets will go from day to day, or week to week.
One solution to this dilemma is dollar-cost averaging, or buying small amounts of a security—usually stocks or index and mutual funds—at regular intervals over time, versus going all-in with a lump-sum investment.
What is dollar-cost averaging?
Dollar-cost averaging is an investment strategy that can produce steady growth in wealth while reducing the risk of mistiming the market’s ups and downs, leading to the worst of investment outcomes—buying high and selling low. More generally, it tends to mitigate the effects of the inevitable swings in share prices, letting an investor take advantage of markets’ long-term tendency to rise.
Anyone with a 401(k) or similar retirement plan engages in dollar-cost averaging by making contributions from paychecks at regular intervals. This is also sometimes called constant-dollar investing because the same amount is contributed to the plan each period, whether weeks or months. Dollar-cost averaging also can be done on different time intervals, with purchases that can be daily or even annually.
How dollar-cost averaging works
To show the effect of dollar-cost averaging, consider this hypothetical example of investing in shares of Company A, with a regular amount of $1,000 invested on the first day of each month for one year at the market price.
A lump-sum investment of $12,000 in January would have given the investor 120 shares, at a cost of $100 per share. With dollar-cost averaging, the investor would accumulate more shares—149.21 compared with 120 for a lump sum—and a lower average cost per share of $80.43 ($12,000 investment divided by 149.21 shares). Hence, the term dollar-cost averaging.
The greater number of shares and lower price would also put the investor in a better position for future gains. Assume that in the following year, Company A’s share price is $100, back to where it started.
The lump-sum investor would have only 120 shares valued at $12,000. The investment hasn’t grown in value during that period. But the investor who used dollar-cost averaging would have 149.21 shares valued at $100 each, or $14,921. That’s almost a 20% gain on the $12,000 invested during the period, even in the absence of share-price appreciation.
Market timing vs. dollar-cost averaging
Of course, in the above example, a lump-sum investor might have waited before jumping in, say until October, when the shares were only $60. In that case, the $12,000 would have bought 200 shares. Or perhaps in May, when the shares were $125 each, the investor thought the shares were ready to surge even higher. In that case, a lump-sum buyer would have ended up with only 96 shares. Either way, it’s a guess, and it’s why market timing is such a challenge.
In the real world, here is how a dollar-cost averaging investor actually would have fared through 20 years, based on one of the many online tools for calculating investment returns. Since the best proxy for the US stock market is the Standard & Poor’s 500 Index, let’s use the Vanguard S&P 500 Index Fund/Admiral Shares (VFIAX) as the investment since people can’t directly invest in the S&P 500.
If the plan began in January 2001 and ended in December 2020, with $1,000 invested each month, the investor would have put in $240,000, and their investment would be worth $797,400 at the end of that period. And if the investor continued the plan for one more year, through December 2021, the wealth total would have grown to $1.04 million.
Potential advantages of dollar-cost averaging
Dollar-cost averaging can provide psychological as well as financial benefits to investors. These include:
- Financial discipline. Dollar-cost averaging may deter investors from jumping in to buy during times of market hype or running for the exits when markets swoon.
- Efficient investing. Investors can take advantage of market volatility to buy when prices are cheaper; during a bear market, for example, more shares are acquired with the constant-dollar investment.
- Future gains. Buying during market swoons lowers the average cost per share over time, which helps investors’ chances of achieving long-term compound growth from a lower cost basis.
- More feasible for most investors. Dollar-cost averaging is something that many more investors have the wherewithal to do because few people, apart from instances of windfalls such as a job performance bonus, have a large amount of cash ready for a lump-sum investment.
By the way, if you're curious about how compounding could potentially affect your investment returns over a period of time, check out Titan's Compound Interest Calculator.
Potential disadvantages of dollar-cost averaging
There are some downsides to dollar cost averaging that include:
- Lump-sum can win. In the example above, if an investor had taken the $1,000 monthly installments that were spread over 20 years and invested all of it in January 2001 in the Vanguard S&P 500 fund, it would have grown to $974,000 by December 2020 instead of $797,400 as a result of dollar-cost averaging.
- Under-investing. Dollar-cost averaging might lead an investor to invest less than they can afford at certain times. Someone who invested $500 a month but could afford $1,000 would miss out on the compound growth the other $500 could be producing. The two biggest ingredients for building wealth through dollar-cost averaging are the amount invested each period and the number of years the investor sticks to the plan.
- Bad investment choices. If the investment choices are losers, dollar-cost averaging can lead to good money following bad. More generally, stock picking and dollar-cost averaging usually don’t mix, and a decline in an individual stock could undo years of patient effort at wealth building. Broad market benchmarks such as diversified mutual funds, index funds, or exchange-traded funds tend to be the most reliable investments for long-term growth through dollar-cost averaging.
- Fees and expenses. If a brokerage charges fees on each transaction, those fees can add up when an investor is making periodic investments. Choosing a brokerage that doesn’t levy a fee per transaction can help avoid this downside for investors with a dollar-cost average plan.
The bottom line
Dollar-cost averaging is a practical alternative for investors to increase wealth over time, toward retirement or other goals, without requiring an initial large sum. Investment advisors can show projections of how wealth increases the longer an investor uses averaging and the more that is invested each period.
Investors who use dollar averaging do forgo the opportunity for big gains if they happen to time the market right. But since few people consistently buy at market lows and sell at highs, dollar-cost averaging offers the opportunity to let erratic market moves balance out so an investor can take advantage of markets’ long-term tendency to rise.