Dollar Cost Averaging: A Good Strategy or Not?

Dollar cost averaging is an investing strategy in which you invest a fixed amount of money at regular intervals. For example, you may review your budget and find that you can invest $500 per month into the stock market.

Every single month you are going to take this $500 and invest it into your desired stock portfolio. You are going to do this regardless of the price of the underlying investments. So, you will continue to invest this $500 each month when the stock market is up and also when the stock market is down.

Dollar cost averaging removes the emotional aspect of investing. In a perfect world, you would be able to save up lump sums of money and time the market to maximize gains. However, it is nearly impossible (even for professional investors) to do this consistently outside of getting lucky.

By dollar cost averaging, you buy more of an asset when it is down in price and less of an asset when it is up in price. For example, say that you have $500 to dollar cost average each month and you are looking to buy shares of a stock that cost $50.

If the price is currently $50 and you dollar cost average $500 that month, you will get 10 shares. Say the next month that the stock drops to $45 per share. If you DCA the same amount of $500, you will be able to purchase 11 shares.

When the stock comes back up you will benefit since you were able to buy an additional share. Dollar cost averaging is not a perfect strategy as some months you will be overpaying for shares. However, it does take the emotion out of investing as it prevents you from being 100% wrong or 100% right.  

Keep in mind that this strategy only works if you take a 30,000 foot view of your investments. We know that over time the stock market as a whole tends to go up. It does not go up each year, and some years it even crashes, but over a 20 or 30 year period, it is reasonable to expect the market to go up.

If you only dollar cost average for a short period of time, it will not work. For example, say that you decide to DCA $500 into the stock market for a year and that throughout the course of the year the stock market was down on average by 10%.

Your yearly contribution of $6,000 would now be worth $5,400 at the end of the year. You may throw your hands up in frustration and jump to the conclusion that dollar cost averaging does not work. However, think about it this way.

When the market goes down, you get to buy at a discount which means you get more shares. If you have a long term mindset and stay consistent with the strategy, you will start to see your portfolio grow when the market recovers as not only the share price increases, but you also have more shares.  

Beyond controlling emotion, dollar cost averaging also helps investors who do not have large sums of money to invest. It would be great if you woke up one day and found that your rich uncle who passed away left you with $1 million to invest.

But for most of us, life isn't that kind. If you only have a few hundred dollars to invest each month, dollar cost averaging may be a good strategy for you. You may already be doing dollar cost averaging without realizing it if you contribute to your employer's 401k plan.

Lump sum investing tends to be better than dollar cost averaging if you have a large sum of funds available. For example, say that you recently inherited $120,000 from a deceased relative. Would it make more sense to invest this all at once or dollar cost average $1,000 per month over the next 10 years?

This should be an obvious one, but it would be much better to invest the $120,000 all at once. Reason being is that you want to get all of this money working hard for you by investing it. You do not want to leave dollars on the sideline that have the possibility of making you money.

Let's look at a practical explanation of this to show the difference between lump sum investing and dollar cost averaging. Assume that you are going to invest this money into the stock market and can earn a reasonable return of 8% per year over a 10 year period.

If you were to dollar cost average $1,000 per month over 10 years, your investments would be worth almost $174,000 given the assumptions above. However, if you were to invest the lump sum of $120,000 and then do nothing, your investments would be worth $259,000 given the same assumptions.

Many people do not have lump sums to invest so this may be a moot point to some investors. The point being made here is that a DCA strategy does not provide the highest possible return. Instead, you are sacrificing the highest possible return for the emotional stability that the strategy provides.

Before implementing a dollar cost averaging strategy, you need to open an investing account. There are lots of account types available, but a good type to start with is a retirement account. Since a DCA strategy uses a long term approach, it can be an appropriate way to save for retirement for some investors.

Your employer's 401k plan is an easy account to start with. It allows you to automate your investing through payroll deductions, contributions are tax deductible, the money in the account grows tax deferred, and your employer may match your contribution.

If you do not have access to a 401k, you can also look into an IRA. An IRA, or individual retirement account, is an account that you can open outside of work which gives you more control over the account itself and the investments within the account.  

There are two main types of IRAs - the Traditional IRA and the Roth IRA. Both of these accounts offer tax benefits and can be opened through an online broker. Keep in mind that there are eligibility rules that you must follow to have an IRA, so check to ensure you can use one of these accounts.  

Once your account is set up, you need to choose the investments you want to buy through the account. The account is not an investment itself. If you have a 401k plan, your plan will offer a small selection of investments. You can only choose from the selection your plan offers.

However, if you have an IRA your investment options are broader. Picking the right investments can be tricky, but a good place to start is an index fund. An index fund tracks the performance of many different stocks all at once.

For example, the S&P 500 index fund tracks the 500 biggest companies in the US. If you were to buy an S&P 500 index fund, you get exposure to all of these companies. Buying an index fund is an easy way to ensure you are diversified so that you protect yourself from too much downside risk.

Keep in mind that this is a generic approach to investment selection. The investments that are right for you will depend upon your age, goals, risk tolerance, and more. If you need help picking your investments, you can work with a financial advisor or learn how to research investments for yourself.  

Next, you need to review your budget to figure out how much you can dollar cost average each month. A good target is to aim to invest between 15% and 20% of your income. Again, this is not a strict rule. Some investors will need to do more or less depending upon their individual needs.

If you review your budget and find that you can't invest 15% to 20% of your income, don't beat yourself up. One of the keys to financial success is building behavioral habits. Even if you can only invest a small amount of money, do it. It will help reinforce the behavior of investing which will make it easier to invest more later on when you are able to.  

Finally, you make dollar cost averaging easy on yourself by automating your contributions. For example, if you opened a Roth IRA, you can typically set up automated withdrawals from your bank account each month with the broker that holds your Roth IRA.

Doing this will provide several benefits. First, it will help you build the habit of investing and can help you stick to a dollar cost averaging strategy when it is challenging to do so. Secondly, it can help show you that dollar cost averaging does work for the right investor.

If you were to dollar cost average $500 per month over 10 years with automated contributions, there is a good chance your portfolio will have grown which will only make you want to continue to invest. Keep in mind that if you set up automatic contributions, you need to make sure you will not need that money for something else.

This is why it is important to review and stick to your budget so that you don't create cash flow problems for yourself when you set up automated DCA contributions. Also make sure that you have a well funded emergency fund that you can use to pay for emergency expenses that are not normally in your budget.  

The bottom line is that dollar cost averaging is an investing strategy in which you invest a fixed amount of money at regular intervals. It is a good strategy for investors who do not have large sums of money to invest all at once or do not have a large investing budget.

Remember, dollar cost averaging is a long term strategy. You can see results quickly depending upon the performance of your underlying investments, but make sure to take a 30,000 foot view and trust that in the long run your investments will perform if they are of high quality.