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The Benefits of Dollar Cost Averaging

February 2, 2017.

When is the best time to invest?

The answer to this age-old investing question is deceptively simple: when prices are low. However, trying to time the market—waiting for the best time to buy or sell an investment—is extremely difficult (if not impossible). Fortunately, there’s a time-tested strategy that can help you buy more when prices are lower and less when prices are higher. It’s called dollar cost averaging.

What is dollar cost averaging?

Dollar cost averaging is the practice of investing a fixed dollar amount on a regular basis, regardless of the share price. It’s a good way to develop a disciplined investing habit, be more efficient in how you invest and potentially lower your stress level—as well as your costs.

Let’s say you invest $100 every month. When the market is up, your $100 will buy fewer shares, but when the market is down, your money will buy more. Over time, this strategy could lower your average cost per share—compared to what you would have paid if you’d bought all your shares at once when they were more expensive than the average.

How dollar cost averaging works: Hypothetical Example

With dollar cost averaging

TimingAmountShare priceShare purchased
Month 1$100$520
Month 2$100$520
Month 3$100$250
Month 4$100$425
Month 5$100$520
Total Invested:Average Cost Per Share:Total Shares Purchased:
$500$3.70135

As you can see above, dollar cost averaging enabled our hypothetical investor to take advantage of a price decline in Month 3, significantly reducing the average cost per share. Despite paying $4 or more per share in four out of the five months, the average cost per share came out to $3.70, and the investor was able to purchase a total of 135 shares.

Without dollar cost averaging

TimingAmountShare priceShare purchased
Month 1$500$5100
Month 2$0$50
Month 3$0$20
Month 4$0$40
Month 5$0$50
Total Invested:Average Cost Per Share:Total Shares Purchased:
$500$5100

By contrast, had all $500 been invested in Month 1, the average cost per share would have been $5 for a total of 100 shares.

In a perfect world, the investor would have placed all the money in Month 3 and walked away with 250 shares. However, it is extremely difficult (if not impossible) to consistently know ahead of time when the best time to buy is, which is why dollar cost averaging is so valuable. By investing frequently and regularly over a long period of time, you’re less likely to miss out on those buying opportunities.

The Benefits of Dollar Cost Averaging

While potentially reducing your cost per share is one compelling reason for dollar cost averaging, there are other benefits to consider.

  • It establishes good investing habits. Even though you know you should be investing regularly, sometimes it’s tempting to spend the money earmarked for investing on other things. If you set up regular, automatic contributions, you’re less likely to miss the money you invest, more likely to develop investing discipline and more likely to stick to your plan.
  • It keeps you open to opportunities. Market timing—trying to pinpoint precisely when the market will reach its peak or hit the bottom, and buying and selling accordingly—is extremely difficult (if not impossible), even for professional investors. Dollar cost averaging helps ensure that you’ll be at the door when opportunity knocks.
  • Minimizing regret. Dollar cost averaging may also help prevent your emotions from undermining your portfolio. When you invest a large sum of money in a single trade, for example, you’re more likely to feel regret if that trade turns out to be poorly timed. Behavioral economists note that most people are inherently loss-averse—they tend to react more strongly to losses (or the prospect of them) than to gains. But with dollar cost averaging, you’re investing smaller sums of money over time, making it easier to stomach a poorly timed investment.

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References

Charles Schwab.  “What is Dollar Cost Averaging.”  What Is Dollar Cost Averaging? | Charles Schwab.  February 2, 2017.

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