The benefits of dollar cost averaging

There are no guarantees when it comes to investing. However, the more you can invest and the longer you stay invested, usually, the greater your chances of accumulating more wealth.

When we talk about professional investors, most people picture people in suits with briefcases walking on NYC’s Wall Street. But what most people don’t realize, is that the majority of actively run funds tend to underperform their respective index benchmarks over a 5, 10, and 20-year time period. Which is hopefully a freeing secret; you don’t need to be an expert to “invest well.”

To counter the desire to market time, consider the investment approach called dollar-cost-average investing. Dollar-cost averaging is also a way to help you get started investing if you are worried about taking on too much risk. Keeping cash in a savings account is safe, but its purchasing power declines over time due to inflation.

Dollar-cost averaging is an investment strategy of investing a small amount of money consistently over time, like when you decide to invest $1k per month for 5 years. The idea is that since it’s difficult to “time the market” (aka invest when it goes down and sell when it goes up), it tends to be better to ignore short term changes in price and continue investing through up and down markets. 

Let’s take a look at a simple example to understand dollar-cost averaging better.

Example Of Dollar-Cost Averaging Versus Lump-Sum Investing

Below are two scenarios of someone investing $500 into a stock. The first table utilizes dollar-cost averaging. Every month, $100 worth of stock is purchased at the current market price, which fluctuates just like in the real world. By the end of month 5, the shareholder has 28 shares because the investor was able to dollar-cost average and buy shares as its price went lower. 

In the second table, lump-sum investing is used instead for the same stock. The entire $500 is invested in month 1 at the current market price of $25, resulting in only 20 shares. In other words, the investor is taking greater risk by investing all their money at a certain price; their return is now dependent on if they “timed” the buy correctly. If the stock goes up, then the investor made a good investment decision. If the shares went down and then up, their lump-sum investing would lead to a lower return. 

This example doesn’t mean that dollar-cost averaging will always result in the best outcome. For example, if a stock was trading at $25 in month 1 and it increased in price for the next five months, the shareholder would be better off investing all $500 in month 1 when the stock price was lowest. They would end up with more total shares versus buying shares in multiple transactions over five months. 

In any case, these theoretical examples are just a simplified way to help you better understand how dollar-cost averaging works versus lump-sum investing.

Think about dollar-cost averaging as wearing a uniform to school. The simplicity of regularly wearing the same old thing frees up your time to do something else, while also minimizing an error in wearing something embarrassing (making the wrong investment). 

For those of you who don’t want to think about when is the best time to invest, dollar-cost averaging is one of the easiest ways to invest. 

How to use dollar-cost averaging in your 401(k)

If your employer offers a 401(k) retirement plan, it’s great to take advantage of that benefit especially if they offer employer matching or profit sharing.

It’s simple to use dollar-cost averaging with a 401(k) plan. Simply decide how much money you want to save each paycheck, choose where to invest it, and your contributions will automatically move from your paycheck into your 401(k) account regularly.

This repetitive inflow of cash can help you build savings and wealth over the long term. Meanwhile, it’s also a great way to avoid stressing about short-term price changes.

Benefits of dollar-cost averaging

Here’s a look at more possible benefits of dollar-cost averaging.

Invest more strategically: By investing a set amount regularly, you open up the opportunity to purchase more shares when prices are low and fewer when they're high.

Automatic discipline: Another way to think about dollar cost averaging is you get to set it and forget it. There’s no need to stress about trading decisions. Dollar-cost averaging helps you stay disciplined by investing on autopilot.

Avoid FOMO: It’s impossible to time the market consistently well, so it’s not worth the headache trying to guess when the best time is to buy. Plus, this strategy keeps you in the game so you don’t have to worry about missing out since you’re always investing. Investing FOMO is one of the hardest types of FOMO to overcome because it's hard to see others get rich when you aren't.

Keeps your emotions in check: Dollar-cost averaging helps prevent you from making rash decisions out of fear or excitement, which could hurt your investment performance. The automation of this strategy helps you stay calm and collected. For this reason, it's also a good technique to use when exiting positions (withdrawing capital).

Who is a good fit for dollar-cost averaging?

Unsure if dollar-cost averaging is right for you? Here's a brief summary of who it can work well for.

Newbies: If you're new to investing, this strategy is like having training wheels for your savings. It’s an easy method to follow and it’s hard to mess up making it a great starting point for those new to investing.

Long-term players: Another good fit are those who want to invest with a long-term mindset and plan to stick around through both the ups and downs. Dollar-cost averaging acts like a steady guide toward financial freedom.

Busy bees: If you are too busy to keep a close eye on the markets all day, consider dollar-cost averaging. After the initial setup, you can shift your focus to other things on your to do list knowing you have a tested investment strategy in place.

Fans of passive investing: Studies have shown that active investing tends to underperform most of the time. Those who favor a more hands-off passive approach to investing can enjoy the simplicity and reliability of dollar-cost averaging.

Some potential downsides to dollar-cost averaging

As great as dollar-cost averaging may sound, there are a few downsides to keep in mind. For example, if your investment account incurs trading fees, those costs could eat away at your earnings over the course of many transactions. Luckily, most online brokerage firms have cut trading fees to $0. 

In addition, since dollar-cost averaging is a form of mitigating risk, you could miss out on investment returns. Dollar-cost averaging also is not immune to market dips, but it can help smooth out the ride.

You should also think about your own investment objectives. If you have a strong conviction in an investment due to its long-term potential and are ready to commit a specific dollar amount into it, a one-time lump-sum transaction may make more sense for you based on your current beliefs in its valuation.

Should I dollar cost average if I have a large amount of cash? 

For investing on longer time frames, DCA has historically outperformed lump-sum investing (aka when you make a big investment all at once). For those individuals who find themselves with a large amount of cash - perhaps it was year end bonuses, inheritances, or something else, the invest as you go approach for DCA may not be the only approach.

For shorter time frames (ie. < 12 months) dollar-cost averaging vs lump-sum investing performance has heavily been tied to where we are in the stock market cycle. 

RBC Global Asset Management ran a short-term study and found that 6-month dollar-cost averaging (DCA) performed better than lump-sum investing in falling markets, but underperformed in rising markets. 

Across a longer study dating back 30 years, they found that dollar-cost averaging underperformed in multiple scenarios with the largest difference for 12-month DCA.

Vanguard also found that lump-sum investing typically outperforms dollar-cost averaging, and dollar cost averaging is still better than leaving everything in cash. However, a big question is what exactly you’re investing in. Vanguard is focused on index investing (ie. not picking just one stock). 

If lump-sum investing feels too stressful for you, feel better knowing that utilizing the simple method of dollar-cost averaging not only takes the emotional jitters of investing out of the equation, it also can put your money in a much better position than just sitting on cash.

In contrast to RBC and Vanguard, a University of Connecticut study found that over a three-year period, DCA performed better than lump-sum. So you can see the data is mixed. Since every research study has its own set of unique parameters, take their results with a grain of salt.

Ultimately, aim to use an investment method that you’re comfortable with and that meshes well with your financial goals and objectives. We believe a key to building long-term investment wealth is to invest regularly and often over as long of a time period possible. 

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