Dollar-cost averaging is a simple but effective strategy for addressing stock market volatility. Instead of trying to time the market with a large lump-sum investment, it invests smaller amounts at regular intervals.
Sometimes, dollar-cost averaging works better than lump-sum investing. Sometimes lump-sum investing works better.
Learn when each option works best.
What Is Dollar-Cost Averaging?
Dollar-cost averaging involves periodically investing a series of equal amounts at regular intervals.
Since the amount invested is constant, this investment strategy buys fewer shares when stock prices are high and more shares when prices are low. It implicitly implements the advice to buy low, sell high.
Dollar-cost averaging addresses the volatility of stock prices by averaging the purchase price over time. As such, it reduces the risk of a bear market or correction, where the stock price might drop soon after making a lump-sum investment.
As a formulaic strategy, dollar-cost averaging avoids emotional decision making, such as the panic-selling, anxiety, fear of missing out and greed that comes with the ups and downs of the stock market. It also helps investors be less emotional about stock market downturns since they are investing smaller amounts at a time.
Dollar-cost averaging is often used with 401(k) retirement plans, where a set percentage or amount of the employee’s salary is contributed to the retirement plan after each paycheck. You invest the money as you earn it. Automatic investment plans for 529 college savings plans operate in a similar manner.
Dollar-cost averaging is best used with index funds and ETFs, as opposed to individual stocks, since a diversified investment will be less volatile.
Sometimes, Dollar-Cost Averaging Is Just Timing the Market
When people have a lump sum to invest, they often insist on investing it in several equal monthly installments because they’ve heard that dollar-cost averaging is a smart way to invest. They want to ease into the target asset allocation, instead of jumping in feet first.
Sometimes they fear the market will crash right after they make a big lump sum investment, even when they already have a lot more money invested.
But, by delaying the full investment of the lump sum, they are investing the money according to a different asset allocation than the one dictated by their risk tolerance. The portion that is not yet invested is effectively invested in cash, altering the mix of investments.
If the argument for keeping the money in cash is based on expectations concerning short-term investment returns, then perhaps you need to revisit the asset allocation for the entire portfolio, not just the new contributions.
This use of dollar-cost averaging, which is also known as time diversification, really is a form of market timing.
Timing the market is not an effective investment strategy. On average, there are 50/50 odds whether the stock market will go up or down on any random day. You can’t consistently predict peaks and bottoms precisely. Since stock market movements are impossible to predict with accuracy, investors who wait to invest may miss out on potential investment returns, not just investment losses. Investors who try to time the market will miss the days with the best returns on investment, reducing their long-term gains. Time in market is more important than timing the market.
Dollar-cost averaging is a good strategy for investing a periodic payment, such as contributions to retirement plans. It buys more shares when prices are low and fewer shares when prices are high.
But, dollar-cost averaging always invests the full sum as soon as the money is available. It doesn’t delay the timing of any investment. It is not an appropriate investment strategy for a lump sum, as opposed to a periodic payment.
It is more important to diversify investments within asset classes than to spread them out over time. In the long term, spreading out a lump sum investment over a few months will not make much of a difference in long-term returns on investment.
When Does Dollar-Cost Averaging Work Well?
Dollar-cost averaging works best when the stock market is volatile and you are investing over a longer period of time.
When the stock market is trending upward, lump-sum investing works better. Dollar-cost averaging misses out on the potential gains you could realize if you had invested the full amount immediately. Delaying the investment of a lump sum means that part of the money is in cash instead of being fully invested.
For example, if you invested a lump sum in the S&P 500 on the first trading day in January 2021, you would have earned a 29% return on investment by the end of the year. If you split the money into equal monthly investments on the first trading day of each month, you would have earned only a 22% return on investment by the end of the year. On the other hand, 2020 was a much more volatile year, causing lump sum investing to yield a 15% return on investment compared with 27% for dollar-cost averaging because of the bear market that occurred in February and March of 2020.
Even when investing during a volatile stock market, the benefit of dollar-cost averaging vs. a lump sum investment is sensitive to the timing of the start of investment. If you start investing immediately before a stock market correction, dollar-cost averaging will perform better than investing a lump sum. But, if you start investing immediately after a stock market correction, dollar-cost averaging will perform worse than investing a lump sum.
Dollar-cost average also works well in a bear market, where the stock market is trending downward, because it reduces the losses as compared with a lump sum investment before a market decline.