Dollar-cost averaging is an investment strategy where instead of investing all available cash/capital at once, investors spread out their position in a stock, ETF, or mutual fund by investing at regular intervals regardless of the underlying price.
Dollar-cost averaging is uniquely effective for passive investors who invest for the long-term, and individual investors who don't spread the cost of a position in a company within a range of the company's valuation.
Pros of dollar-cost averaging:
- Reduces irrational behaviour caused by emotionally-driven investment decisions where investors make poor decisions trying to time the market.
- Reduces the risk involved in making large stock investments since the spread-out schedule helps to accumulate the asset at various prices that can be more favourable in the long-term.
- Promotes investment discipline and routine.
- It is a convenient investment option that can be set up automatically with your stock brokers such as Vanguard, Schwab, and others.
- It is generally an affordable method of investing since you can invest relatively small sums of money regularly as opposed to saving large amounts to invest.
Cons of dollar-cost averaging:
- Chance of incurring higher transaction costs per each transaction. Keep in mind the risk is low nowadays and it really depends on your broker's fees. Large brokers like Vanguard, Robinhood, and Schwab allow you to execute these transactions with virtually no fees.
- Risk of over-diversification when the underlying conditions that make the asset valuable change. This is particularly important for buying individual stocks where fundamental factors could change the value of the company over time.
- Potentially harder to manage, especially for keeping track of all the transactions that take place and their respective implications on tax.
- Potentially lower expected returns if the alternative of investing all of the money at once turns out to be at a lower cost than the average and the stock/fund rises overtime
How does dollar-cost averaging work?
There are two traditional issues encountered when investing in the stock market; finding what stock/security to buy and at what price or time to buy it. Dollar-cost averaging aims to solve the second issue by allowing investors to forget about the timing/cost basis of the asset and focus on being disciplined and consistent with your stock investing.
People who advocate for dollar-cost averaging frequently use phrases like "time in the market beats timing the market", which encourages investors to invest in a set stock on a set time schedule.
Dollar-cost averaging vs. Lump sum investing
There are two ways that you can invest in a stock, ETF, or a mutual fund. Either save a large amount of money and invest it all at once, or invest in regular intervals. The first option is what is referred to as lump-sum investment and the second is dollar-cost averaging. As you previously saw there are unique benefits and drawbacks for each strategy.
However, it is recommended that you follow the strategy that best suits you. More on this below.
When do I use dollar-cost averaging?
Dollar-cost averaging is most effective when an individual is not concerned with growing their investment account very quickly but rather wants to invest consistently and have that money grow for a personal finance goal like retirement. An important factor to keep in mind is how much money you have saved and how much you are willing to invest.
Dollar-cost averaging is particularly effective when you don't have a lot of money upfront to invest, but you can easily set aside a specific amount every so often and invest that in stocks, ETFs, and mutual funds.
This approach is highly encouraged by successful individuals like Tony Robbins, Warren Buffet, and Jack Bogle and is an approach that suits most people for growing their money over time. As it is often mentioned, transactions and other types of fees should be strictly monitored to make sure brokers take the minimum amount possible from your returns.
Lastly, if you want the potential to earn higher returns, you can use a portion of your portfolio to take on higher-risk investments.
What is an example of dollar-cost averaging?
Now that you know all the important information about dollar-cost averaging investing let's go through an example:
Say that you can invest 10% of your $6,000/month paycheck in an S&P 500 index and the index had the following price fluctuations over a year.
| S&P 500 Index Value | Contribution | Shares bought | Shares owned | Total Value | |
| Month 1 | $ 100.00 | 600.00 | 6.00 | 6.00 | $ 600.00 |
| Month 2 | $ 110.00 | 600.00 | 5.45 | 11.45 | $ 1,260.00 |
| Month 3 | $ 105.00 | 600.00 | 5.71 | 17.17 | $ 1,802.73 |
| Month 4 | $ 94.00 | 600.00 | 6.38 | 23.55 | $ 2,213.87 |
| Month 5 | $ 90.00 | 600.00 | 6.67 | 30.22 | $ 2,719.66 |
| Month 6 | $ 92.00 | 600.00 | 6.52 | 36.74 | $ 3,380.10 |
| Month 7 | $ 105.00 | 600.00 | 5.71 | 42.45 | $ 4,457.72 |
| Month 8 | $ 110.00 | 600.00 | 5.45 | 47.91 | $ 5,270.00 |
| Month 9 | $ 120.00 | 600.00 | 5.00 | 52.91 | $ 6,349.09 |
| Month 10 | $ 100.00 | 600.00 | 6.00 | 58.91 | $ 5,890.90 |
| Month 11 | $ 120.00 | 600.00 | 5.00 | 63.91 | $ 7,669.09 |
| Month 12 | $ 125.00 | 600.00 | 4.80 | 68.71 | $ 8,588.63 |
| Dollar-cost average | Total contribution | Total shares bought | Investment value | Profit/loss | |
| $ 105.92 | $ 7,200.00 | 68.71 | 8588.63 | $ 1,388.63 |
In this scenario your dollar-cost average was $105.92 per share, your total contribution was $7,200.00 in the year, and your profit at the end of the year is $1,388.63.
In contrast, if you were to have invested the lump sum of $7,200 at the end of the year, your profit for that year would be equal to $0. However, if you already had the money saved up from the starting month and didn't contribute anything for that whole year your profit would be equal to (($7,200/100)*125)-($7,200) = $1,800.00.
| S&P 500 Index Value | Contribution | Shares bought | Shares owned | Total Value | |
| Month 7 | $ 105.00 | 7200.00 | 68.57 | 68.57 | $ 7,200.00 |
| Month 8 | $ 110.00 | 0.00 | 0.00 | 68.57 | $ 7,542.86 |
| Month 9 | $ 120.00 | 0.00 | 0.00 | 68.57 | $ 8,228.57 |
| Month 10 | $ 100.00 | 0.00 | 0.00 | 68.57 | $ 6,857.14 |
| Month 11 | $ 120.00 | 0.00 | 0.00 | 68.57 | $ 8,228.57 |
| Month 12 | $ 125.00 | 0.00 | 0.00 | 68.57 | $ 8,571.43 |
| Dollar-cost average | Total contribution | Total shares bought | Investment value | Profit/loss | |
| $ 105.00 | $ 7,200.00 | 68.57 | 8571.43 | $ 1,371.43 |
Does dollar-cost averaging work?
According to a 2012 study conducted by Vanguard, historically investing your money in a lump sum vs. dollar-cost averaging produced better results 66 percent of the time. The longer the time horizon, the greater the chance that investing all at once beat dollar-cost averaging.
“We conclude that if an investor expects such trends to continue, is satisfied with his or her target asset allocation, and is comfortable with the risk/return characteristics of each strategy, the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible,” the Vanguard study authors wrote.
Keep in mind the study was conducted by Vanguard, a big benefactor of dollar-cost averaging but the general results are probably correct.
Beyond Dollar-cost Averaging
As it was previously mentioned, dollar-cost averaging is a good idea if you want your money to grow passively without a lot of work involved. However, the more risk you take, the higher the potential returns. For this reason, it is highly recommended that you keep a portion of your stock portfolio that you feel comfortable with to be more active and take higher risks.
Now, this doesn’t mean gambling, in fact, gambling your money is a habit that can seriously affect your financial well-being. Instead what this means is applying simple principles that have made many investors successful by having a strong understanding of an industry and investing in companies when they are undervalued. Although it is easier said than done, and we have a whole guide you can check out here.
If you want to learn more about how you can get stock financials, key metrics, and growth metrics right on Excel or Google Sheets in seconds, check out www.wisesheets.io
We wish you all the best in your stock investment journey.
To your investing success,
The Wisesheets Team
2 Responses
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