The Dollar-Cost Averaging Strategy

Investing in the stock market can feel like navigating a roller coaster of ups and downs. For "buy and hold" investors looking at long-term appreciation in the market, dollar-cost averaging presents a strategic method to mitigate market volatility and reduces the guesswork of trying to time investments.

By consistently investing a fixed amount into an investment at regular intervals, dollar-cost averaging allows investors to purchase more shares when prices are low and fewer when prices are high, averaging the investment cost over time.

This approach eliminates the temptation of trying to "time the market" - guessing when prices are low and offering the greatest chance for appreciation. By purchasing a fixed amount of a stock fund, for example, regularly, the price you pay is averaged.

An Automatic Approach 

Dollar-cost averaging is about making regular, disciplined investments regardless of market conditions. This approach can particularly appeal to those wary of market fluctuations or who procrastinate over finding the "perfect" time to invest. Automating investments at regular intervals (for example, each pay period) ensures continuous market participation, which can lead to potential long-term growth and profit accumulation.

Especially for those who may worry about choosing the right time to invest, this automatic approach means less stress and less second-guessing of your investing decisions.

Yes, dollar cost averaging means you may buy when prices are high. But you will also purchase a portion if the price falls - lowering your overall investment cost. The philosophy here is to buy smaller amounts over time at regular intervals rather than investing, for example, an entire year's worth of savings at once.

When the market hits a downturn (and it always does), traditional investors tend to sell off shares that are losing ground and look for better deals elsewhere. This strategy is the exact opposite of dollar cost averaging. When using this strategy, investors don't look at market downturns as something to worry about but rather as an opportunity for growth. When prices are down, your set investment amount will buy more.

Timing the Market Versus Dollar-Cost Averaging

Let's compare the two investment philosophies: trying to time the market and dollar-cost averaging in a period of market decline.

When trying to time the market, investors try to wait for the "right" time when prices are low. The investor, for example, would purchase $10,000 worth of stock at $100 per share. But if the price slides to $70 a share over the coming months, the investor would lose 30% or $3,000.

On the other hand, let's say an investor takes that $10,000 and purchases the same stock over an entire year. Over time, the stock price fluctuates (some will cost $100 a share, some $70 a share, and a few at prices in between). This approach means that the "average" cost of your shares will be lower than it would have been if purchased all at once - potentially resulting in higher buying power depending on how stock prices move over time.

When you use a dollar-cost averaging approach to buying stock, you spend the same amount during a calendar year. But if prices decline or fluctuate in a range, you may own more shares for the same investment. Then, when the price of the shares increases, you will have more shares and may experience higher gains.

If prices continuously increase without a temporary decline, making one purchase could be the better strategy. The problem is that it's impossible to say what will happen in the stock market over the short term. But over the long term, studies have shown that the most important thing is to be "in" the market without taking money in and out.

Who Benefits the Most From Dollar Cost Averaging?

The dollar cost averaging approach is a solid option for those who invest a portion of each paycheck, and for those who come into a large sum of money they'd like to invest while protecting against the possibility of a sudden price decline.

It's also a promising approach for investing in broad market indexes versus one individual stock. While broad averages have continuously increased over the long term, some individual stocks lose all their value. In the latter case, buying more of a stock that goes to zero wouldn't be the best idea!

The Takeaway

While dollar cost averaging is not a one-size-fits-all solution, its disciplined approach can be a practical component of a diversified investment strategy, suitable for a wide range of financial goals and risk tolerances.