Dollar cost averaging is a popular investment strategy that usually gets even more popular in environments like this, where all-time market highs and political uncertainty have people worried that the next big stock market crash could be just around the corner.
And while dollar cost averaging can absolutely be a good way to ease yourself into the market, it’s a strategy whose benefits are often oversold and misunderstood.
In this post we’ll explore exactly what dollar cost averaging is, what the benefits and downsides are, and what alternatives you have so that you can make the right decision for your situation.
What Is Dollar Cost Averaging?
Dollar cost averaging is the practice of investing your money a little bit at a time instead of all at once.
Let’s say that you just received your bonus and you have $4,800 that you’d like to invest for the long term. You could invest it all right away, or you could dollar cost average by investing, say, $400 per month over the course of a year.
Why would you do the latter? The idea behind dollar cost averaging is two-fold:
- You reduce the risk that a market crash in the near future would affect all of your money.
- By investing the same amount every month, you automatically buy more shares when the market is down and fewer when the market is up. This is the “buy low” half of the “buy low, sell high” strategy and could, theoretically, improve your returns — though we’ll largely debunk this theory below.
To be clear, this is not the same as making a consistent contribution each month or every time you receive your paycheck. That’s a good practice, but it’s technically not dollar cost averaging because you are actually investing all of the money you have available to save as soon as it’s available.
Dollar cost averaging is really for situations like receiving a bonus or inheritance, or wanting to move money from a savings account to an investment account. Rather than investing some of your income as you receive it, these situations give you an unexpected sum of money that you have to decide what to do with.
The Benefits of Dollar Cost Averaging
There are two big arguments you’ll hear in favor of dollar cost averaging, one of which is truer than the other.
1. It Reduces Risk
Dollar cost averaging reduces your investment risk, which is the main benefit. By keeping some of your money out of the market for some period of time, your overall investment strategy is temporarily more conservative and less susceptible to a market crash.
There are other ways to reduce risk, which we’ll get into below, but the real reason this matters is because this reduced risk can make it emotionally easier to start investing. And since investing is such an important part of building long-term wealth, anything that helps you start is worth a look.
2. You Buy Low
Some proponents of dollar cost averaging argue that it can actually increase your returns. Because you contribute a pre-defined amount of money at pre-defined intervals, you will automatically buy more shares when the stock market is down and fewer when the market is up. Which means that you should get better bang for your buck.
This is partially true. Dollar cost averaging does cause you to buy more shares when the market is down, and it can lead to better returns in a declining market. But as you’ll see in the next section, this isn’t the expected outcome.
The Downsides of Dollar Cost Averaging
While dollar cost averaging does reduce your investment risk, there are a few downsides to consider before jumping in.
1. Lower Expected Returns
Almost every investment decision involves a trade-off between risk and return. If you want the chance at better returns, you have to accept a larger risk of not receiving them.
The same is true with dollar cost averaging. Although it can lead to better returns in some cases, most of the time the reduced risk comes with reduced returns.
The reason is simply that the stock market goes up more often than it goes down. So by investing your money in little bits over time instead of investing it all at once, your odds of missing out on gains are greater than your odds of avoiding losses. According to a 2012 Vanguard study, investing all of your money at once would historically have produced better returns than dollar cost averaging about 66% of the time.
Nothing is guaranteed, but the fact of the matter is that dollar cost averaging will typically lead to lower returns in exchange for less risk.
2. Straying from Your Plan
One of the biggest pieces of your investment plan is your asset allocation, which is essentially how you choose to divide your money between high-risk, high-return investments like stocks and low-risk, low-return investments like bonds.
Your asset allocation is the primary way you can manage your expected risk and return, and you should choose your asset allocation knowing ahead of time that you will occasionally lose money in down markets. The big question is how much you’re willing to lose at any one time. The less you’re willing to lose, the more conservative your asset allocation should be.
Whatever you decide, dollar cost averaging by definition causes you to stray from that asset allocation plan. By temporarily keeping some of your money in cash, you are temporarily investing in a portfolio that is more conservative than you originally decided was appropriate based on your needs and appetite for risk.
So if you don’t feel comfortable investing your money all at once, it’s possible that the real problem is that you’ve chosen an asset allocation that’s more aggressive than it should be. If that’s the case, the solution may simply be to invest your money all at once into an asset allocation that’s more conservative, and therefore less susceptible to a market crash.
Finally, dollar cost averaging makes your life more complicated. Setting up and monitoring periodic contributions takes more work and more time than investing your money all at once.
And again, if you could accomplish the same end goal simply by choosing a more conservative asset allocation, it might be worth doing so simply to make your life easier.
Should You Dollar Cost Average?
With all of that background, the big question is this: should you dollar cost average or invest your money all at once?
Here’s my take:
- The most important thing, by far, is to save money and stay invested for the long term. If dollar cost averaging helps you do that with less anxiety, then go for it.
- From a purely analytical standpoint, it’s typically more efficient to invest your money all at once into an appropriate asset allocation. If pure rationality is what gets you going, that may be the better approach.
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.