Dollar-cost averaging is a strategy where you invest your money in equal portions, at regular intervals, regardless of which direction the market or a particular investment is going. In other words, your purchases occur regardless of the changes in price for the stock or other investment, potentially helping reduce the impact of volatility on the overall purchase. This can serve as a risk management trading strategy if you end up buying more when the price is relatively lower and buying less when the price is relatively higher.
Trading using dollar-cost averaging
Let’s look at a hypothetical example to illustrate how dollar cost averaging works. Suppose you have $5,000 to invest and have identified a stock you would like to purchase. However, you are unsure when and at what price you would like to buy the stock. Using a dollar-cost averaging approach, you might decide to invest $1,000 a month for 5 consecutive months. In an ideal scenario (assuming you have made the decision to use dollar-cost average), the stock price will decline after your initial trade so that you are dollar-cost averaging in at lower prices (i.e., a lower average stock price compared with the initial price).
Check out the table below to see how this strategy might play out using varying stock prices. Note that this example excludes trading costs and assumes fractional shares enabled.
After using all of your intended $5,000 for this trade, you purchased 253.4 shares for a dollar-cost average stock price of $19.73. This compares favorably with buying 250 shares if you had used all of the $5,000 to make a lump sum investment at the original $20 per share purchase price.
It’s worth noting that you may already be utilizing a dollar-cost averaging strategy. If you have a 401(k) or another type of defined contribution investment plan, your contributions are allocated to one or more investment options on a regular, fixed schedule, regardless of what the market is doing.
Should you use dollar-cost averaging?
Ideally, you would buy an investment at a low point and sell at a high point. But that’s not the way things usually happen in real life.
As a risk management strategy, dollar-cost averaging attempts to help address the risk of using all your intended funds for a particular investment at a point in time when the price may be relatively high or volatile. Market timing is exceedingly difficult, even for professional investors. A key advantage of using a strategy like dollar-cost averaging is that it can help mitigate the effects of investor psychology, as it relates to trying to time the market. With a dollar-cost averaging approach, you may avoid making a counter-productive decision due to emotions like fear or greed (like buying more when prices are going up or panic selling when prices are going down). Moreover, dollar-cost averaging might be appropriate if you think there is a possibility that your investment opportunity may decline over the short term (to some extent), but you believe it will rise over the longer term.
The drawbacks of dollar-cost averaging should be apparent. If the price of the investment rises over the course of executing a dollar-cost averaging approach, you will end up buying fewer shares than had you made a lump sum investment at the outset. Suppose the dollar-cost average was $21 using our example above. By the end of making your fixed investments at regular intervals, you would have ended up with 238 shares (compared with 250 shares if you had made a lump sum investment on January 15).
Also, if you are implementing a dollar-cost averaging approach, those funds in waiting are typically held in cash or cash equivalents that earn very low rates of return. Note that this last point does not apply to a scenario like your contributions to a 401(k), because you are making your contributions to those accounts as you earn funds (and not with funds that you already have and are waiting to deploy).
You should also be aware of any trading fees you might incur in your trading account making multiple transactions.
In sum, while dollar-cost averaging may help mitigate some of your risk, it might also mean you could forgo some return potential.