Dollar-cost averaging is a common investment strategy where you invest the same amount of money at set intervals. This takes the guesswork out of market timing and you don’t need to worry about trying to “time the market.”
Because the amount you invest remains constant, you are able to buy more shares when the price is low and fewer shares at a higher price. The goal is to buy more shares at a lower average cost per share over time.
This sounds like a great way to invest, and it can be. But there are times when there are better ways of investing than dollar cost averaging. For example, many experts believe that lump sum investing can result in better returns than investing a little bit over time. The idea behind lump sum investing is that the longer you have your money in the market, the more money you will make. Lump sum investing works best if you have a large amount of money to invest at one time.
Lump sum investing vs. dollar cost averaging. Here is an online tool that calculates actual returns using dollar cost averaging vs. investing in a lump sum. If you play with the tool for a few minutes, you will find examples where lump sum investing wins out, and examples when dollar cost averaging brings better returns.
Even though lump sum investing can result in better returns over the long run, let’s look at an example of dollar cost averaging and why it makes sense to invest that way.
Dollar Cost Averaging Example
Let’s take a look at using dollar cost averaging to max out a Roth IRA. The max you can invest in a Roth IRA in 2008 is $5,000. Many people don’t have $5,000 to put down at once, but they may be able to break it down into monthly payments.
Here is how dollar cost averaging would look if you broke down an IRA investment over 12 months (The numbers represent a fictional fund):
|Investment date||Amount invested||Price per share||# Shares purchased
|Total||$4999.92||$30.46 avg.||164.15 shares owned|
In this example, you can see that as the price per share goes up you can buy fewer shares, and as the price per share goes down you buy more shares. Note that the average share price is $30.46, which is less than the share price during January. In this example, dollar cost averaging comes out ahead of investing in a lump sum, but it could very well come out with the opposite result.
Pros of Dollar Cost Averaging
Affordability. Dollar cost averaging is more affordable and allows people to treat investing like paying a bill. It is difficult for most people to invest a $5,000 lump sum to max out a Roth IRA or Traditional IRA. However, many people may be able to afford a monthly installment of $416.66, which will put them on pace to max out their IRA for the year.
A similar example is investing in a 401(k) plan, which is deducted directly from your paycheck. Even if you could afford to invest the $15,500 limit at the beginning of the year from your cash savings, your paycheck wouldn’t be large enough to cover that. Most people also rely upon their paycheck to pay bills throughout the month. A 401(k) plan forces the participant to use dollar cost averaging.
Convenience. It is easy to set up dollar cost averaging as a monthly payment and incorporate it into your budget.
Cons of Dollar Cost Averaging
Lump sum investing can result in better returns. Lump sum investing can often result in better returns because you have your money in the market longer. This is based on the idea that the longer you have your money in the market, the better your returns are over the long run.
More fees. Dollar cost averaging also means making more transactions, which can result in higher brokerage fees. You won’t pay these fees if you are investing in a 401(k), but you could if you were making monthly purchases of a stock or mutual fund. You can mitigate these fees by investing quarterly or semi-annually.
The point of dollar cost averaging is not to try and time the market – it is to save or invest with amounts of money you can afford. The amount you can invest could be as low as $25 a month or into the thousands. The point is to get into the habit of investing, and dollar cost averaging provides investors with an easy and affordable way to invest money on a regular basis.