What is Dollar-Cost Averaging? (And How it Can Help You Manage Investment Risk)

Is now a good time to invest in the stock market? This is a common question for investors. 

The uncertainty and volatility of the stock market can make any investor nervous. And it does not matter if we are at record highs or experiencing a market correction or a bear market. The unpredictability is always there.

The reality is, no one can predict the stock market. However, you can manage investment risk without predicting the markets with the investment strategy, dollar-cost averaging. 

The challenges of trying to predict the stock market

When the economy is strong and the stock market is making record highs, it is common to hear opinions that the stock market is overvalued and that we are due for a pull back. 

So do you wait? What if the stock market takes a nosedive right after making an investment? 

That fear can delay your decision to invest. 

But there is a risk to waiting. What if the stock market does not pull back, but continues to make new highs? Now when do you jump in?

When the stock market is in a correction or a bear market, you may think it’s better to play it safe and wait until we’ve hit the bottom. But how do you know when the stock market has hit the bottom? You may have your money in cash waiting for the bottom while the stock market recovers and goes on to make new highs. This can prove extremely frustrating for investors.

Know this: you don’t have to put all your investable funds in the stock market all at once. And you don’t have to try to time the market. Instead, you can invest using a strategy called dollar-cost averaging.

What is dollar-cost averaging?

Dollar-cost averaging is building your investment by purchasing a fixed dollar amount at regular time periods

Instead of making a lump sum investment, you make the investment over time. You can divide the amount to invest weekly, monthly, quarterly, yearly, or even longer. The frequency is flexible, but what is most important is to make the investment according to the predetermined schedule. The strategy is simple, but it requires discipline and consistency.

If you have a long-term time horizon, there is nothing wrong with making a lump sum investment. But if you have a lower tolerance for risk, you should consider this strategy.

An example of dollar-cost averaging at work 

Here’s a hypothetical example: Let’s say you have $5,000 to invest. Instead of making a lump sum investment, you decide to spread it out over five months. You invest $1,000/month on the first business day of every month beginning in January. You make the purchase regardless of the market price. 

Over the five month period, the price of your investment fluctuates which is typical of stocks, mutual funds and exchange traded funds (ETFs). In a hypothetical example, the price in January was $25, in February it was $24, in March it was $20, in April it was $23, and in May it was $26.

MonthMonthly InvestmentPriceShares Purchased

At the end of five months, you would have accumulated a total of 213.16 shares for the average price of $23.6.

By committing to invest a fixed dollar amount periodically at predetermined times, you take advantage of the market’s volatility. You end up buying more shares when the price is lower and less shares when the price is higher. At the end of the period, you should have a favorable average price and at the same time reduced your risk by not investing all your investable funds at once.

Another way to think about dollar-cost averaging: This is how investing in your 401(k) works. When you enroll in your 401(k) plan, you are electing to have a fixed percentage of your salary deferred and invested in the mutual funds you selected. The money is invested at the same time every month.

4 advantages to choosing dollar-cost averaging

1. It takes the emotions out of investing

When you stick to your plan by investing a specific amount at specific times, you don’t have to think about it. It doesn’t matter what the market is doing or what’s happening in the news. Your buy decision has already been made.

2. You automatically buy more shares when the price is lower

It’s never enjoyable to see the value of your investments decline during a correction or bear market. But if you are on a dollar-cost averaging plan, it’s actually beneficial. By sticking to the plan, you will accumulate shares at a reduced price. You’ll be buying when the stock market is on sale.

3. Dollar cost averaging is a great way to build wealth

You don’t have to wait until you have a large sum to invest. You can start investing right away by contributing as little as $25, $50, $100 on a regular basis. Mutual funds can be purchased directly from the fund company with no commissions. (However, make sure you are aware of the mutual fund’s minimum investment requirements). The major online brokers provide commission free trades for stocks and ETFs. The no and low cost options make the dollar-cost strategy more effective because more of your money is going to work for you.

4. This strategy can help reduce your risk

By not putting all your investable funds in the stock market, you have money on the sidelines should the market decline. But at the same time you are still invested and are able to benefit from a rising market. 

One final point: You should only invest in the stock market if you have a long-term time horizon. This is true whether you are making a lump sum purchase or dollar-cost averaging. The stock market is volatile and we can expect years with negative returns. Dollar-cost averaging can reduce the risk but can’t eliminate it. 

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