Once you begin building your investment portfolio, you are bound to hear about a technique called dollar-cost averaging, which has been around for generations. Simply put, an investor who follows a dollar-cost averaging plan will invest in a given security at regular intervals and/or in fixed dollar or share amounts, no matter the state of the market.
Read on to learn more about this method, how it works, and why it might help you to invest in a steady manner with proven results.
- Dollar-cost averaging is working your way into a position by slowly buying smaller amounts over a longer period of time rather than investing assets in a lump sum all at once.
- The secret to dollar-cost averaging is that it helps you strip emotion out of the challenge of capital allocation.
- One downside of dollar-cost averaging is that, during market bubbles, your average cost basis will be higher than it otherwise would have been.
What Is Dollar-Cost Averaging?
Dollar-cost averaging can best be described as an approach for investing at fixed intervals to slowly build a position in a security. This can be done with either a set amount of currency or by acquiring a fixed number of share units. That is, instead of investing your assets in one lump sum, you work your way into a position by slowly buying smaller amounts over a longer period of time.
This method is effective because it spreads the cost basis out over many years and at varied prices, which makes for a sort of buffer against future changes in market price. It means that during times of rapidly rising share prices, you will have a higher cost basis than you otherwise would have had. During times of falling stock prices, you will have a lower cost basis than you otherwise would have had. They key is to stick to the system.
"Cost basis," at its most basic, is how much you paid for an asset, but it is also a term of art in the tax code that plays a part in how your gains will be taxed over time.
How Dollar-Cost Averaging Skips the Emotional Factor
There is some debate about how much dollar-cost averaging can reduce market risk, but most agree that people who follow this strategy might have a better defense against the emotional dangers of trading in an iffy market. In other words, people who use this method won't be as vulnerable to overconfidence or panic during times of extreme stock market volatility.
In effect, the secret to dollar-cost averaging is that it helps an investor strip emotion out of the challenge of capital allocation. For new investors, particularly those who are buying baskets of securities or things such as low-cost index funds, this can be a major help. In truth, irrational investor behavior abounds in trying times.
How to Build a Plan
To begin a dollar-cost averaging plan, you need to do three main things:
- First, decide exactly how much money you can afford to invest each month. You'll need to be certain that the amount you commit to is within your budget and financially prudent so that this figure can remain the same through time.
- Next, select an investment, fund, or group of assets that you want to hold for the long-term (at least five or ten years).
- Lastly, contribute at regular intervals. This can be weekly, monthly, or quarterly, as long as you stick to the system of adding that money into the security you have chosen. If your broker offers it, you could even set up an automatic purchasing plan so the process happens without any action on your part and at little to no expense. You may even be able to do this without a broker, such as through your bank or credit union, or by using an investing app.
A Step-by-Step Look
The way a dollar-cost averaging plan works can be best explained by walking through an example. Suppose that you have $15,000 you'd like to invest in shares of ABC, Inc.
The date is January 1. You have two options: You can invest the money as a lump sum now, walk away, and forget about it, or you can set up a dollar-cost averaging plan and ease your way into the stock. You opt for the latter and decide to invest $1,250 each quarter for three years.
Over the next three years, you invest your money at the prices and amounts as follows:
|Stock Price||Investment||Shares Purchased|
|1st Quarter Year 1||$50||$1250||25.00|
|2nd Quarter Year 1||$40||$1250||31.25|
|3rd Quarter Year 1||$70||$1250||17.86|
|4th Quarter Year 1||$50||$1250||25.00|
|1st Quarter Year 2||$30||$1250||41.67|
|2nd Quarter Year 2||$20||$1250||62.50|
|3rd Quarter Year 2||$25||$1250||50.00|
|4th Quarter Year 2||$32||$1250||39.06|
|1st Quarter Year 3||$35||$1250||35.71|
|2nd Quarter Year 3||$51||$1250||24.51|
|3rd Quarter Year 3||$65||$1250||19.23|
|4th Quarter Year 3||$50||$1250||25.00|
Had you invested your $15,000.00 at the start of the time period, you would have bought 300 shares at $50.00 per share. At the ending stock price of $50.00 per share at the close of year three, your position would have been worth exactly the same $15,000.00.
Instead, through the system above, you ended up investing $15,000.00 and getting 396.70 shares. Your fixed investment of $1,250.00 per quarter was able to buy more shares when the stock price fell, and fewer shares when the stock price went up. Even though the ending stock price was $50.00, the exact same amount as three years prior, your stake has a market value of $19,839.50.
To take it one step further, under the dollar-cost averaging plan, your stake would break even at $15,000.00 if the stock were trading at $37.81, which is a 24.38% decrease from the initial purchase price.
Real World Success Stories
After the stock market collapse of 2009, many people stuck with their 401(k) accounts and continued to add funds at the same steady pace and amounts, in spite of the falling market. It became clear that this approach had major benefits. Those low-cost-basis purchases helped them to bring down their overall cost bases, so when the market recovered years later, they were able to enjoy the rewards for their patience and discipline.
The main downside of dollar-cost averaging is that if you experience a stock market bubble or are averaging into a position that has a major increase in value, your average cost basis will be higher than it otherwise would have been.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.