Dollar-cost averaging is one of the easiest techniques to increase your returns without taking on additional risk, and it’s a great way to practice buy-and-hold investing. Dollar cost averaging is even better for people who want to set up their investments and don’t have to deal with it often. It is one of the most powerful and easiest investment strategies and ideal for individual investors.
Here’s what dollar-cost averaging is and how you can use it to maximize your investment gains.
What is dollar cost averaging?
Dollar-cost averaging is the practice of putting a fixed amount into an investment on a regular basis, usually monthly or even biweekly. If you have a 401(k) retirement account, you’re already practicing dollar-cost averaging, adding your investments to each paycheck.
By doing this over time, you spread out buying points and avoid the practice of “timing the market.” Timing the market means throwing all your money into it at once, and it can be a dangerous practice if you end up investing when a stock hits its peak, risking a huge loss if the stock falls from that point. With dollar cost averaging, you buy over time and average your purchase prices.
Dollar-cost averaging makes a volatile market work in your favor. By adding money regularly, you will buy when the market is lower. This lowers your average purchase price and essentially acquires more shares. When the market rises, you buy fewer shares with your regular contribution, but you already have shares from previous purchases, so you still make a profit and don’t miss out entirely.
Additionally, dollar costing can provide other benefits. People get scared when stocks fall, and to avoid more short-term losses, they stop buying stocks when they get cheap. By regularly creating a buying plan when the markets (and you) are calm, you avoid this psychological bias and benefit from falling stock prices when everyone else is getting scared.
You can accumulate even more shares if you also reinvest your dividends, also applying dollar-cost averaging to quarterly dividend payments. You’ll convert your cash dividends into more shares over time, and you don’t have to do anything once you set up the program. Slowly you will start earning dividends on your dividends!
It only takes a little time up front to create a reinvestment plan. Then you put it on autopilot and let your broker handle the rest. And that’s great for individual investors who want to spend as little time as possible on their investments.
Example of calculating dollar cost
Imagine an employee who earns $3,000 every month and contributes 10 percent of it to his 401(k) plan, choosing to invest in an S&P 500 index fund. Because the price of the fund fluctuates, the number of shares purchased is not always the same, but $300 is invested each month. The table below shows this example over a 10-month period.
| Month | Contribution | Price of the fund | Bought shares | Shares held | Total value |
|---|---|---|---|---|---|
| 1 | $300.00 | $100.00 | 3 | 3 | $300.00 |
| 2 | $300.00 | $97.50 | 3.08 | 6.08 | $592.80 |
| 3 | $300.00 | $101.30 | 2.96 | 9.04 | $915.75 |
| 4 | $300.00 | $85.45 | 3.51 | 12.55 | $1,072.40 |
| 5 | $300.00 | $91.23 | 3.29 | 15.84 | $1,445.08 |
| 6 | $300.00 | $93.20 | 3.22 | 19.06 | $1,776.39 |
| 7 | $300.00 | $96.50 | 3.11 | 22.17 | $2,139.41 |
| 8 | $300.00 | $100.54 | 2.98 | 25.15 | $2,528.58 |
| 9 | $300.00 | $101.43 | 2.96 | 28.11 | $2,851.20 |
| 10 | $300.00 | $105.00 | 2.86 | 30.97 | $3,251.85 |
You can see that the value of employees’ investments increased by 8.4 percent over their total contributions of $3,000, despite the fund only increasing by 5 percent over that period. That’s because the employee was able to buy a larger number of shares when the price was lower, taking advantage of market volatility.
Does dollar-cost averaging really work?
It may depend on your specific situation, but dollar costing has been a successful way to invest for many people over time. The question centers on whether you should time your purchases based on market conditions, or simply buy consistently over time using the dollar-cost averaging method. Timing the market has proven to be very difficult and most people are better off with a consistent investment plan.
Another problem is that most people invest money as they earn it, likely through a workplace retirement plan such as a 401(k). Calculating costs on a dollar basis makes sense here, because you invest what you can, as soon as it is available to invest. However, if you inherited a large sum of money, say $100,000, you don’t want to spread it out over years to invest. In that scenario, it’s best to get it invested relatively quickly, but you can still spread your purchases over a few months to take advantage of the potential volatility.
Disadvantages of dollar costing
The biggest drawback to dollar-cost averaging is that in a market that generally rises over time, you’re probably better off getting fully invested as quickly as possible. But because most people save and invest because they make money, dollar-cost averaging is the best option.
Another disadvantage is that you still have to choose good underlying investments. If dollar-cost averaging makes you a bad investment, the way you bought in won’t save you. The approach works best with broad-based funds such as an S&P 500 index fund, which have performed well over long periods of time.
How the average dollar costs
There are two ways you can set dollar cost averaging for your account: manually and automatically. If you go the manual route, you simply choose a set date (monthly, biweekly, etc.) and then go to your broker, buy the stock or fund and then you’re done until the next date.
If you choose to go the automatic route, it will take a little more time upfront, but it will be much easier later. Plus, it will be easier to continue buying when the market drops because you don’t have to do anything. While setting up your automatic purchases may seem like a chore, it’s actually simple.
Almost any broker can set up an automatic buying plan, so use Bankrate’s reviews of the major players to find brokers that offer other features like great customer service and educational tools.
Here are the steps to make dollar cost averaging completely automatic.
1. Choose your investment
First you want to determine what you are buying. Do you want to buy shares? Or do you opt for an exchange-traded fund (ETF) or investment fund?
- If you choose to buy individual stocks, they are more likely to fluctuate significantly than a fund. But it can be difficult to find a brokerage that lets you buy stocks on autopilot.
- If you buy a fund, it should fluctuate less than an individual stock, and it is also more diversified, so you will be less affected if an individual stock in the fund falls sharply.
Less experienced investors usually choose a fund, and some of the most diversified funds are based on the Standard & Poor’s 500 index. This index includes hundreds of companies from all major industries and is the standard for a diversified portfolio of companies. If you want to buy an S&P index fund, here are some of the best choices.
In either case, you should note the ticker symbol for the security; that is the short code for the share or fund.
2. Contact your broker
So you have made your investment choice. Now see if your broker will allow you to set up an automatic purchase plan for that investment. If so, you are ready to move on to the next step.
However, some brokers only allow you to set up an automatic plan with mutual funds. In that case, you might consider opening another investment account that allows you to do exactly what you want. There are also other solid benefits to having multiple brokerage accounts, and you can usually get a lot of value from having multiple accounts.
3. Determine how much you can invest
Now that you have a broker who can execute your auto trading plan, it’s time to figure out how much you can invest on a regular basis. With any type of stock or fund, you want to be able to leave your money in the investment for at least three to five years.
Because stocks can fluctuate widely over short periods of time, you can try to let the investment grow for a while and ride out any short-term price drops. This means that you must be able to live only on your uninvested money during that time.
So start with your monthly budget and determine how much you can spend on investing. Once you have an emergency fund, how much can you invest and not need? Even if it isn’t much at first, the most important thing is to start investing regularly.
Dollar-cost averaging is now cheaper than ever because all the major brokers now charge no commissions on stock and ETF trades, and the best mutual fund brokers let you skip the fees on thousands of mutual funds. That means you can really start with any amount of money and build your nest egg.
4. Schedule your automatic subscription
You can set up the automatic trading plan with your broker using the ticker symbol for the stock or fund, how much you want to buy regularly and how often you want the trade to be executed. The exact process for setting this up varies from broker to broker, but these are the basics you’ll need anyway. If you have any questions, your agent can help you.
And if your stock or fund pays dividends, it may be a good time to set up automatic dividend reinvestment with your broker. Any cash dividend will be used to buy new shares, and you can often even buy fractional shares, which will leverage the full value of the dividend, rather than letting it sit in cash for a long time and earning little or almost nothing. So even once the next dividend occurs, your dividend will continue to earn dividends.
In short
Dollar-cost averaging is a simple way to reduce your risk and increase your returns, and takes advantage of a volatile stock market. If you set up your brokerage account to automatically and regularly buy stocks or funds, you can sit back and do the things you love, instead of spending your time investing. When investing, you can often achieve better results with less effort.
Please note: Bank interest Brian Baker contributed to an update to this story.
