Among the numerous investment strategies available, dollar-cost averaging is a popular and widely used approach. Its proponents range from Warren Buffett to average investors. So, should you use dollar-cost averaging in your own investments?
Dollar-cost averaging is simple to understand and easy to implement, and chances are you are already applying it with some of your investments. Read on to understand how this strategy works in practice, and determine whether or not it is right for you.
What is Dollar-Cost Averaging?
Dollar-cost averaging is the idea that you will invest the same sum of money into your portfolio at regular intervals. This can be for any investment, though it is usually associated with securities that can have heavy movement, such as stocks, ETFs, or index funds.
In other words, you are focused on the amount you are investing, not the quantity of the security that you are buying. By investing the same amount of money irrespective of price, dollar-cost averaging takes a good chunk of risk out of the equation.
As an example, Dan decides that he wants to purchase $500 worth of Apple (NASDAQ:AAPL) every month, and starts using this strategy in March 2023. He does this the first of every month, so on March 1st, with a share price of $144.72, he is able to purchase 3.46 shares (let us assume that Dan uses a broker that allows him to acquire fractional shares). At the beginning of April, the share price of Apple has risen to $165.50, allowing Dan to purchase 3.02 shares of Apple for the same $500 investment.
Dan purchases $500 of Apple stock every month, regardless of share price, slowly but surely acquiring a larger holding. In essence, Dan is “averaging” out the price at which he is acquiring the asset (hence the name). The TipRanks’ Dollar-Cost Averaging Calculator will allow you to experiment with different publicly-traded securities, investment amounts, and periods of time to better understand how this strategy can work for your desired investment preferences.
What are the Benefits of Dollar-Cost Averaging?
There are two principle benefits of dollar-cost averaging: a reduction of risk and promoting a strategy of making regularly investments.
(1) Reduction of risk: In the aforementioned example with Dan, Apple’s stock had a strong year in 2023, raising the value of his initial investment. Had he decided to go with another stock that did not perform as well throughout 2023, his starting investments would have lost value though he would have been able to acquire more shares as the price dropped.
By averaging out the price of purchase, you are also reducing your risk of market volatility. Markets go up, and markets go down, but Dan will continue to purchase $500 worth of Apple shares. Some months this will purchase more shares, and some months it will be less. Unlike other investors who seek to time the market perfectly, the fluctuations do not influence Dan’s investments. His risk, just like his purchases, averages out over time.
(2) Consistent investing: The best investment practices are the ones that ensure you continue saving and investing (instead of consuming). Budgeting frameworks such as the 50-30-20 rule, whereby you are allocating 50% of your after-tax income to needs, 30% to wants, and 20% to savings and investment, are meant to help individuals save and invest.
Dollar-cost averaging meshes nicely with this strategy, by helping to create the environment where you will be consistently putting money aside for the future.
Anyone who has a 401(k) or makes regular contributions to an Individual Retirement Account (IRA) is essentially partaking in dollar-cost averaging. With every paycheck (or at other regular intervals), you are sending money into your chosen funds. These contributions are being made irrespective of the market’s or fund’s performance, allowing you to steadily grow your retirement savings.
Who Should Use Dollar-Cost Averaging?
Dollar-cost averaging is a useful strategy for those who want to regularly increase their savings, but without the concerns or the hassle that comes along with constantly monitoring the markets.
It is a good strategy for those who have lower risk profiles, as it enables investors to take advantage of the market without having to worry about its regular fluctuations. It follows that individuals using this strategy do not need to stay updated regarding every single dip and bump in the markets, as their purchases, amounts, and timing have already been decided.
Dollar-cost averaging can be a wise approach to follow if you consider yourself a generally risk-averse investor. Pairing this strategy with investing in a mutual fund can provide an even greater level of security, as your fortunes will not be dependent on the performance of a single company but rather spread out over multiple assets and even industries.
Conclusion: Growing Your Savings Through Dollar-Cost Averaging
Dollar-cost averaging is a straightforward approach to growing your wealth. By adhering to this strategy, you will make regular contributions to your investment portfolio without relying on the overall market environment.
It is not geared for those who may try to beat the market by timing their investments. While this approach has the potential to outgain dollar-cost averaging during certain periods of time, it also carries inherent risks and the potential for larger losses.
At the end of the day, the purpose of investing is to create money for future use. Dollar-cost averaging guarantees that a portion of your after-tax income is allocated exactly for this purpose.
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