What is dollar-cost averaging?
Dollar-cost averaging, or DCA, is an investment strategy in which an investor systematically adds fixed dollar amounts to their portfolio on a pre-set schedule.
The dollar-cost averaging approach disregards share price fluctuations, making it a staple of disciplined investors who seek efficient, low-cost, long-term growth.
How dollar-cost averaging works
A great example of long-term dollar-cost averaging is how it's used in 401(k) plans, where employees invest regularly regardless of the investment's price.
When it comes to a 401(k) plan, employees have the freedom to decide how much they want to contribute and which investments they want to invest in.
Contributions are automatically made every pay period. Depending on the markets, employees might notice a varying number of securities being added to their accounts.
But dollar-cost averaging isn't limited to just 401(k)s. Investors can use it to regularly buy ETFs or mutual funds, whether in another retirement plan (e.g., a traditional IRA) or a taxable brokerage account.
Hypothetical dollar-cost averaging example
Say you acquired a $10,000 windfall and wanted to invest it in the stock market, but you were nervous about timing, worried about what might happen if the market suddenly drops right after you add your cash to your portfolio.
DCA could be a way to alleviate this concern. With a DCA plan, you select a time period in which you will invest the entire amount.
For example, let's say you choose to invest over a year and invest on a quarterly basis. In this case, you would invest $2,500 every quarter until the whole amount was invested.
What are the advantages of dollar-cost averaging?
One of the most important benefits of dollar-cost averaging is that it reduces the impact of timing on your investment results. For example, if the stock market immediately rises after your initial investment, you would have been better off throwing it all in at once.
On the other hand, if the market falls, you would have been better off waiting. However, the reality is that no one has a crystal ball that tells them the direction the market is going. But with a DCA plan in place, you have made some investment if markets rise right away. If it falls, you will have some money on the sidelines that can get invested at better prices.
With a DCA plan, it doesn't matter quite as much how the market performs immediately after your investment. In contrast, if you have a larger amount of new cash to invest, the stress of getting the timing right often makes it harder to decide. DCA can ease this stress and help investors put their money to work.
What are the disadvantages of dollar-cost averaging?
One potential disadvantage is fairly simple: most of the time, the market goes up.
For example, in the last 30 years, the broad US market, represented by the Russell 3000 Index, has been up 64% of months, 71% of quarters, and 73% of years. So, most of the time, the sooner you have your money in the market, the more return you will ultimately realize.
To illustrate, we ran a comparison of a simple four-quarter DCA vs. going "all-in" at once. In this test, we assumed a $10,000 investment in the US market—either invested in equal parts over four quarters or once in a lump sum. We tested this starting every quarter from 1992 to 2022.
The result?
The DCA only did better in 28% of periods. On average, investing all at once made $398 more than using a DCA.
Now, you may be thinking that the better option is the 'all-in' approach. But remember, most people add to their savings over time (assuming they have a long-term goal), making timing less important.
Now, let's revisit our example of a $10,000 windfall. Of course, in isolation, there's some timing risk of investing all that money at once, but this money probably isn't your only investable asset.
For example, you might regularly contribute to a 401k or save a portion of your monthly income for retirement. This kind of periodic savings is a type of DCA in and of itself.
In other words, even if your timing is unlucky on the $10,000 windfall, it isn't the last time you put money into the market.
Is dollar-cost averaging right for you?
Dollar-cost averaging helps investors automate their investments, which may help keep costs low and mitigate large market swings.
In long-term investing, the most important thing you should consider (and sometimes the hardest) is to simply get started. It is easy to look back at history and see that frequently, investing all at once works out a bit better.
However, in real life, you don't get to invest in the past; you can only focus on the future. So, if the stress of putting a significant lump sum investment into the market gets in the way of getting started, then dollar-cost averaging may be a good solution.
Ultimately, this is a conversation to be had with your planner. They can help you discuss the pros and cons and gain some perspective on how impactful the timing will or won't be on your long-term plan. That way, you can make the most informed decision possible and ensure that any new cash works toward your long-term goals.
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