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Dollar-cost averaging definition
Dollar-cost averaging is the strategy of investing in stocks or funds at regular intervals to spread out purchases. If you make regular contributions to an investment or retirement account, such as an individual retirement account (IRA) or 401(k), you may already be dollar-cost averaging.
The advantage of dollar-cost averaging: by investing in smaller set amounts over time, you'll buy both when prices are low and high. This smoothes out your average purchase price.
Dollar-cost averaging can be especially powerful in recessions and bear markets. Committing to this strategy means that you will be investing when the market or a stock is down, and that’s when investors can potentially score the best deals.
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The three benefits of dollar-cost averaging
It's easy to imagine scenarios in which a lump-sum purchase beats dollar-cost averaging. But in general, dollar-cost averaging provides three key benefits that can result in better returns. It can help you:
Avoid mistiming the market
Take emotion out of investing
In other words, dollar-cost averaging saves investors from their psychological biases. Because investors swing between fear and greed, they are prone to making emotional trading decisions as the market gyrates.
However, if you’re dollar-cost averaging, you’ll also be buying when people are selling fearfully, scoring a nice price and potentially setting yourself up for long-term gains. The market tends to go up over time, and dollar-cost averaging can help you recognize that a stock market crash or bear market could be a great long-term investing opportunity, rather than a threat.
Is dollar-cost averaging a good idea?
Perhaps. It’s true, by dollar-cost averaging, you may forgo gains that you otherwise would have earned if you had invested in a lump-sum purchase and the stock rises. However, the success of that large purchase relies on timing the market correctly, and investors are notoriously terrible at predicting short-term movement of a stock or the market.
If a stock does move lower in the near term, dollar-cost averaging means you should come out way ahead of a lump-sum purchase if the stock moves back up.
Examples of dollar-cost averaging (versus lump purchases)
To understand how dollar-cost averaging can benefit you, you need to compare it to other possible buying strategies, such as purchasing all your shares in one lump-sum transaction. Below are a few scenarios that illustrate how dollar-cost averaging works.
Scenario 1: Lump-sum purchase
First, let’s see what happens with a $10,000 lump-sum purchase of ABCD stock at $50, netting 200 shares. Let’s assume the stock reaches the following prices when you want to sell. The column on the right shows the gross profit or loss on each trade.
Profit or loss
This is the baseline scenario. Now let’s compare it with others to see how dollar-cost averaging works.
Scenario 2: A falling market
Here is where dollar-cost averaging really shines. Let’s assume that $10,000 is split equally among four purchases at prices of $50, $40, $30 and $25 over the course of a year. Those four $2,500 purchases will buy 295.8 shares, a substantial increase over the lump-sum purchase. Let’s look at the profit at those same sell prices again.
Profit or loss
With dollar-cost averaging, you actually have an overall gain at $40 per share of ABCD stock, below where you first started buying the stock. Because you own more shares than in a lump-sum purchase, your investment grows more quickly as the stock’s price goes up, with your total profit at an $80 sale price more than doubled.
Scenario 3: In a flattish market
Here’s how dollar-cost averaging performs in a market that’s going mostly sideways, with a few ups and downs. Let’s assume that $10,000 is split equally among four purchases at prices of $50, $40, $60 and $55 over the course of a year. Those four purchases will get 199.6 shares, basically what a lump-sum purchase would get. So the payoff profile looks nearly identical to the first scenario, and you’re not much better or worse off.
This scenario looks equivalent to the lump-sum purchase, but it really isn’t, because you’ve eliminated the risk of mistiming the market at minimal cost. Markets and stocks can often move sideways — up and down, but ending where they began — for long periods. However, you’ll never be able to consistently predict where the market is heading.
In this example, the investor takes advantage of lower prices when they’re available by dollar-cost averaging, even if that means paying higher costs later. If the stock had moved even lower, instead of higher, dollar-cost averaging would have allowed an even larger profit. Buying the dips is tremendously important to securing stronger long-term returns.
Scenario 4: In a rising market
In this final scenario, let’s assume the same $10,000 is split into four installments at prices of $50, $65, $70, and $80, as the market rises. These purchases would net you 155.4 shares. Here’s the payoff profile.
Profit or loss
This is the one scenario where dollar-cost averaging appears weak, at least in the short term. The stock moves higher and then keeps moving higher, so dollar-cost averaging keeps you from maximizing your gains, relative to a lump-sum purchase.
But unless you're trying to turn a short-term profit, this is a scenario that rarely plays out in real life. Stocks are volatile. Even great long-term stocks move down sometimes, and you could begin dollar-cost averaging at these new lower prices and take advantage of that dip. So if you’re investing for the long term, don’t be afraid to spread out your purchases, even if that means you pay more at certain points down the road.
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How to start dollar-cost averaging
With a little legwork up front, you can make dollar-cost averaging as easy as investing in an IRA. Setting up a plan with most brokerages isn't hard, though you’ll have to select which stock — or ideally, which well-diversified exchange-traded fund — you’ll purchase.
Then you can instruct your brokerage to set up a plan to buy automatically at regular intervals. Even if your brokerage account doesn’t offer an automatic trading plan, you can set up your own purchases on a fixed schedule — say, the first Monday of the month.
You can suspend the investments if you need to, though the point here is to keep investing regularly, regardless of stock prices and market anxieties. Remember, falling markets are an opportunity when it comes to dollar-cost averaging.
Here’s one final trick to add a little extra juice to dollar-cost averaging: Many stocks and funds pay dividends, and you can often instruct a brokerage to reinvest those dividends automatically. That helps you continue to buy the stock and compound your gains over time.