Dollar Cost Averaging: An Overview

Dollar cost averaging is a very simple, yet very effective approach to investing. Dollar cost averaging is a long term investing strategy that is implemented by investing a fixed amount of money into the same stock or fund over a period of time. 

A common saying among investors in support of dollar cost averaging is “time in the market beats timing the market.” The idea behind this saying is that investing in the market over a long period of time will outperform attempts at trying to make perfect trades by buying at the lows and selling high. No one truly knows when the market is low or high. This means that you are losing opportunity by not being in the market sooner. The market is unpredictable and by using this method you greatly reduce your risk. Chances are, if you contribute to a 401k, 457b, 403b or similar employer sponsored retirement plan, you are already implementing a dollar cost averaging strategy, unless you are switching funds frequently.

How To Implement a Dollar Cost Averaging Strategy

There are typically a few ways that a dollar cost averaging strategy is used. As talked about previously, your retirement plan at work is likely dollar cost averaged. You contribute a certain amount into your 401k, for example, every week, bi-weekly or maybe even monthly. Another example would be maxing your Roth IRA each year with one lump sum contribution. This is dollar cost averaging on an annual basis rather than per pay period like your 401k might be, but the premise is the same.

Similarly, you may contribute to an individual account in which you manually invest money weekly, bi-weekly, monthly, etc. Assuming you put money into the same funds/stocks on a regular basis this is another form of dollar cost averaging. Even automatically reinvested dividends could be considered dollar cost averaging. This would typically be on a quarterly basis.

Another commonly used application is when one has a lump sum of money they want to invest. Rather than investing all the money at once, they will invest the money across periodic intervals. This tends to make people feel like they are lessening their risk, but as we will talk about later on it may be counterintuitive. 

Dollar Cost Averaging: In Practice

Dollar cost averaging allows you to purchase more shares when the price is low and fewer shares when the price is high. This gives you an average price per share somewhere in the middle.

Let’s use our friend Tom as an example. Tom is a new investor and has decided to start investing on January 1st. Tom will invest $1,500 per month, on the first of each month, into an index fund called ABC. Looking forward six months, the price of ABC on January 1st is $50, February 1st – $54 dollars, March 1st – $42 dollars, April 1st – $45 dollars, May 1st – $46 dollars and on June 1st – $53 dollars.

Each month Tom’s $1,500 would have bought a different number of shares.This is due to the difference in share price. 

To calculate how many shares Tom can purchase each month we will divide the amount invested by the price of the shares at the time. Here’s the math for January: $1,500 invested / shares of ABC at $50 each = 30 shares.

January – 30 shares, February – 27.78 shares, March – 35.71 shares, April – 33.33 shares, May – 32.61 shares and June – 28.30. After six months, Tom would own a total of 187.73 shares of ABC with an average cost of $47.94 per share ($9,000 invested / 187.73 total shares = $47.94). He invested a total of $9,000 that is now worth $9,949.69.

It is important to note that this example worked out favorably for Tom because of the overall increase in share price of our hypothetical fund called ABC. Dollar cost averaging does not reduce the risk associated with a market decline. It can though, potentially increase the performance of an investment, providing the price of the investment increases over time. This is why dollar cost averaging the entire market, or more likely a fund that tracks the market, which has historically gone up over time, is a popular strategy. 

Potential Drawbacks

There are a few potential drawbacks to a dollar cost averaging strategy. The first potential drawback to dollar cost averaging is the possible loss of gains. For example, if Tom could have predicted the future and invested the entire $9,000 on March 1st when the shares were the lowest, he would have seen a $2,356.84 gain by June 1st. Conversely, if he had invested the entire $9,000 on February 1st when the shares were the highest, he would have seen a loss of $163.49. This drawback is only relevant if you are successfully able to buy and sell at the perfect time. Unfortunately, most of us don’t have the ability to see the future.

The next potential drawback is the potential for increased broker fees by making more trades. There are many low cost brokerages and more and more that offer free trades out there, making this much less of an issue than it once was. 

Lastly, the reason that dollar cost averaging makes sense is the same reason that it might not. The idea is that the market will go up over time so buying over consistent time periods will allow you to capitalize on this. By not investing as much as you can, as soon as you can, you are, in theory, allowing the market to rise before investing more. This really only applies when dollar cost averaging a lump sum of money though. You can’t invest money that you don’t have.

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