Dollar-cost averaging explained: is this a smart way to invest?

As a new investor, figuring out how to invest can be confusing. You have to learn so many concepts to feel like you understand what’s going on.

The only reason I knew how to start when I first had money to invest was because I had been reading about it for at least a year while I was finishing up college. I had no money to invest at the time, so all I could do was soak up knowledge.

Thankfully, I came across a concept called dollar-cost averaging that made total sense to me. It helped me realize that I don’t need to spend hours each month analyzing investments to reach my long term goals.

Here’s what you need to know.

What is dollar-cost averaging?

Dollar-cost averaging is a method used to determine when to invest your money as a long-term investor. 

You don’t try to time the market with dollar-cost averaging. Instead, you invest a set amount of money evenly throughout the year on a regular schedule.

This may sound counter-intuitive. Why would you invest regardless of the price of the investment? Well, the math works out over long periods of time.

With dollar-cost averaging, you buy both at times when the markets are high as well as when markets are low. 

Due to the long-standing history of the stock market always increasing over long periods of time, your investments should eventually end up worth more than they were when you initially invested. 

Of course, this assumes you have a long enough investing time frame and the long-term rising value trend of the stock market doesn’t fail. No one has a crystal ball and the trend could break in the future.

Is dollar-cost averaging a good idea?

Dollar-cost averaging is a good idea for the average investor making investments throughout the year. It takes a lot of guessing out of the equation and makes investing a straightforward process.

While you could technically receive higher returns if you’re an expert stock market timer, it isn’t likely to work out. 

Professional traders spend their entire career learning the ins and outs of the stock markets and other investments. Even then, they don’t always come out ahead.

That said, dollar-cost averaging isn’t smart in every case. If you have a lump sum to invest, you could miss out on potential returns by dragging the investment out over several months if the market goes up. 

At the same time, dollar-cost averaging a lump sum when the market is going down could result in you owning more shares.

You have to decide if you’re comfortable with dollar-cost averaging for both regular investments and lump sums. Reviewing the pros and cons of dollar-cost averaging can make this decision easier.

Who should use dollar-cost averaging

While most people who plan to invest long-term can benefit from dollar-cost averaging, it may not be the right investment for you, if:

• You plan to invest in a low-return, stable stock with a steady gain with little or no downturn over time.
• You don’t intend to keep your money in the same stock, but plan to jump in and out of the market, making short-term investments.
• You prefer to be continually monitoring your stock prices and trying to anticipate constant shifts in stock price.
• You invest with a broker who charges high fees, thus eating up your profits with every additional stock buy you make per year.
• You don’t think you can handle buying instead of selling when stock prices are falling.

On the other hand, if you are a newer investor and want to mitigate your overall risk, dollar-cost averaging might be a great option for you. Especially if you use the right online brokerage.

For new investors, Public app is a great option.  They don’t charge fees, you can buy fractional shares (perfect for dollar-cost averaging), and there’s a huge social component. You can follow others to see what they’re saying about stocks, what they’re buying, and more. 

It’s really the perfect solution for newbie investors who want to dollar-cost average. 

How do you start dollar-cost averaging?

Starting to dollar-cost average is easier than you think. First, choose how much you want to invest over a period, such as a year. Next, decide how often you wish to invest.

Divide the amount you’re investing by the number of times you plan to invest. This gives you the amount to invest each period.

To fully invest the set amount each period, you’ll want to use an investment account that allows you to buy partial shares of your investment of choice. As I mentioned, Public offers partial shares of thousands of companies with no commission fees, so you can dollar-cost average with a dollar amount instead of buying full shares.

If you can only buy whole shares, you may not invest the total amount each period. This results in not meeting your investment goal or the need to track how much you haven’t invested so you can invest it in the future.

Mutual funds allow partial share investments and some brokerage firms are allowing partial shares of other types of investments, as well.

Once you have the amount to invest each period and your investments picked, you could set up dollar-cost averaging in one of two main ways.

Automatic investments

Many investment services allow you to set up automatic transactions on a regular basis, such as once per month or once every two weeks. Setting up automatic investments makes dollar-cost averaging even easier.

The potential downside of this method is forgetting about an upcoming investment. If you do this, you could accidentally overdraft your account and get charged fees by your bank.

Set calendar reminders

The other option is setting calendar reminders so you don’t forget to invest based on your schedule. This takes more discipline as you have to take action each time period to invest.

If the markets make you emotional, it can be easy to skip investments using this method. This would result in different returns than standard dollar-cost averaging.

Services you can use to dollar-cost average

Consider some of these options if you’re ready to start dollar-cost averaging and don’t have an investment account.

TD Ameritrade

TD Ameritrade is one of the largest and oldest brokers out there, which means they’ve had plenty of time to really get things right. They’re well-suited for new investors with commission-free investment options, intuitive platforms, access to financial news, and plenty of research tools.

You can also use TD Ameritrade’s thinkorswim tool, which is a professional-level trading tool that can help you perform stock analysis and test strategies and look out for potential risks and rewards.

With TD Ameritrade, you can choose to invest in stocks, ETFs, mutual funds, futures, and cryptocurrency.

Robinhood

Robinhood is a fairly new player in the investment industry, but they’ve been extremely innovative and are app-based. Robinhood tends to be popular with younger users and beginner investors.

Robinhood focuses on opening up investing to everyone through no commission fee trades. They also allow you to buy partial shares of investments, so you can invest any amount you can afford to set aside.

Investments come in the form of stocks, ETFs, gold, cryptocurrency, and options using their platform. Robinhood also has a large educational database of articles you can read to learn what you need to know to start investing.

E*TRADE

E*TRADE is another great platform, offering stocks, bonds, mutual funds, ETFs, futures, and FOREX trading. You’ll get zero commissions on stocks, ETFs, and options, all with a well-designed mobile app that can help you keep track of your investments easily.

You can choose a traditional brokerage account or a managed portfolio with a low annual advisory fee of 0.30% and just a $500 minimum to get started. Plus, you’ll have access to E*TRADE’s large library of resources, so you can start truly understanding your investments.

The benefits of dollar-cost averaging

Dollar-cost averaging offers new and experienced investors many benefits. 

You don’t have to worry about timing the market

As a dollar-cost averager, you don’t have to worry about timing your investments to get the best deal. You’ll buy at times when the markets are high and other times when the markets are low. You’ll also buy at points in between.

Timing the market is challenging because you have to be right multiple times. First, you have to buy at the bottom. Then, you have to sell at the top. To make matters even more complex, you have to find another bottom to buy in again and repeat the process over and over.

You get to buy during the dips without overanalyzing

One of the best parts of dollar-cost averaging is buying the dips without overanalyzing. When markets are crashing, it’s tempting to think they’re going to keep going down more. 

In this case, some people delay investments but never feel comfortable putting their money back in until the market recovers. This results in missing out on returns.

When you dollar-cost average, you buy at regular points throughout a stock market dip. This helps you take advantage of lower costs consistently.

It makes investing simple and reduces emotion

Dollar-cost averaging is an extremely easy concept to understand. Once you set a goal, invest on that schedule. That’s it.

Dollar-cost averaging reduces the emotion in the investing equation, too. 

It’s easy to get swept up in market highs and buy more than you should, thinking the markets will keep going up. 

It’s also easy to get panicked during crashes, thinking the market won’t recover. This often results in panic selling. With dollar-cost averaging, you keep investing and wait out the peaks and dips thanks to your long-term strategy.

Here’s a simple example of how dollar-cost averaging works

The easiest way to explain how dollar-cost averaging works is by showing an example. Let’s say you want to max out your Roth IRA in 2020, which would require investing $6,000 over the course of the year.

You get paid twice per month. To max out your Roth IRA with dollar-cost averaging, you could invest $500 once per month or you could invest $250 once per paycheck. 

Here’s an example of how per paycheck dollar-cost averaging would work.

The drawbacks of dollar-cost averaging

While I love dollar-cost averaging, I know there are faults with the system. It isn’t perfect every single time.

If you have a lump sum to invest, delaying investing could reduce returns

Dollar-cost averaging works well when you’re investing money from a source, such as a paycheck, that comes in throughout the year.

But what happens when you get a lump sum to invest? Say you sell your house and have $10,000 you want to invest in the market. Should you invest $1,000 per month for 10 months or invest the full $10,000 upfront? Ultimately, that’s up to you.

If the market ends up going up consistently over the next 10 months, investing upfront would give you the best returns. You’d be better off dollar-cost averaging if the markets steadily decline over the next 10 months.

Unfortunately, the right answer is only apparent in hindsight, so it’s up to you to decide which is better for you.

You buy during the peaks

Dollar-cost averaging means you buy during peaks in investment prices, even when it’s clear the stock market is overvalued. By buying at these times, you get fewer shares per purchase.

It isn’t an excuse to not pay attention to other parts of investing

Dollar-cost averaging isn’t the sole solution to figuring out how to invest. It only takes away the timing aspect of your purchases. 

You can’t ignore choosing correct investments, paying attention to tax strategy, rebalancing your portfolio, and other investing concepts because you dollar-cost average.

Summary

Dollar-cost averaging is a way to remove one of the many factors you need to worry about when you’re investing. 

By investing on a set schedule, you don’t have to worry about timing the market. You can even automate your investments.

Once you know your goals, calculate your per period investment amount, and get started.

Read more:

• 6 Easy Ways To Start Investing With Little Money
• Best Investment Accounts For Young Investors