Personal Finance Insider writes about products, strategies, and tips to help you make smart decisions with your money. We may receive a small commission from our partners, but our reporting and recommendations are always independent and objective.
As the COVID-19 crisis has led to mandatory shutdowns and shocking unemployment numbers, investors have also faced unnerving levels of stock market volatility.
It seems like nearly every day the market is swinging up or down by 5 percentage points or more. And individual stocks have often jumped or plummeted by 10% or more in single trading sessions.
In wild times like these, the dollar-cost averaging method of investing could help investors avoid knee-jerk decision-making that hurts them in the long run. Below, we look at how dollar-cost averaging works, its pros and cons, and how to decide if it’s right for you.
What is dollar-cost averaging?
Dollar-cost averaging is the process of investing the same amount of money in a particular asset over consistent intervals of time. Investors can choose to buy shares of that asset once per week, per month, per quarter, or according to any other investment schedule.
With the dollar-cost averaging method, you invest the same amount every time, regardless of the asset’s price. The goal behind dollar-cost averaging is to reduce the effects of market volatility. When the market goes down, you’re able to buy more shares per dollar. And when the market is up, those same dollars buy you fewer shares.
How dollar-cost averaging works
Let’s imagine that you have $300 to invest each and every month. You decide to use that money to buy shares of an S&P 500 index fund on a monthly basis. The index fund that you’ve chosen is currently trading at $30 per share.
In the first month, your $300 would buy you 10 shares of the fund ($300 divided by $30 per share = 10 shares). But if the fund were to increase in price to $50 per share, your $300 would buy you six shares ($300 divided by $50 per share = six shares). On the other hand, if the fund were to decrease in price to $20 per share, your $300 would buy you 15 shares ($300 divided by $20 per share = 15 shares).
Pros and cons of dollar-cost averaging
There are a few benefits and also some potential drawbacks to dollar-cost averaging. Here’s what you need to know.
The biggest advantage to dollar-cost averaging is that it spreads out your risk. For example, let’s say that you had $1,000 to invest in a stock that’s currently trading for $100. If you invested all your money at once, your $100 would buy you 10 shares.
But let’s say that you divide your $1,000 into four equal investments of $250, spread out over four months. Here’s an example of how things could play out:
So, in this example, you’d end up with 11.34 shares instead of 10 shares at the end of the four-month period. Those 1.34 extra shares would also mean extra profit for every dollar of future stock price growth. That’s the potential benefit of spreading out your risk over time.
The second advantage of dollar-cost averaging is that it can remove emotion from the investing process. In market environments like we’re dealing with now, where huge swings are happening each day, it can be tempting to try to “time” the market.
But just because a stock or fund has dropped 30% this week, doesn’t mean that it’s going to rebound by 20% next week … or even next month or next year. Trying to guess when to hop in and out of stock positions is tough for investment professionals, much less the Average Joe.
So dollar-cost averaging can keep you from panic selling when the market is acting wild. And it can also help you resist the temptation to go all-in on high-risk, speculative investments.
The downside to dollar-cost averaging is that the market tends to go up more than it goes down. For this reason, Vanguard says its research has shown that lump-sum investing has historically outperformed dollar-cost averaging.
To understand why this is the case, let’s revisit our example from above. This time, we’ll see how dollar-cost averaging can hurt you when the market is trending up.
In this case, you’d end up with 9.04 shares after the four-month investing period instead of the 10 you could have had if you’d invested all your money at once. So while dollar-cost averaging acts as a hedge against bear markets, it will underperform lump-sum investing during long bull market periods.
Long-term S&P 500 data shows that bull markets have historically lasted longer and been more pronounced than bear markets. So, mathematically, lump-sum investing is often the best choice. Also, if you’re investing in stocks or funds that pay a dividend, dollar-cost averaging could cause you to miss out on one or more dividend payments.
Is dollar-cost averaging right for you?
The truth is that many people don’t have a lump sum to invest. Instead, they plan to budget a certain percentage of their income each month towards retirement savings. And for these slow-and-steady investors, dollar-cost averaging their monthly contributions is a great choice.
Even if you do have a lump sum to invest, dollar-cost averaging could still be a smart move during times of high market volatility.
Finally, you may find that dollar-cost averaging simply reduces your anxiety around investing. And those emotional benefits may make it the best choice for you, even in spite of the risk of a lower overall return.