Break it down: Dollar cost-averaging
Editorial staff, J.P. Morgan Wealth Management
- Dollar-cost averaging is the process of investing your money in equal amounts and at regular intervals.
- When using dollar-cost averaging, you can buy fewer of the more expensive shares and more of the cheaper shares as the price of your investment fluctuates over time.
- A dollar-cost averaging strategy helps take the guesswork out of having to monitor the price of an asset on a daily basis to determine when to buy.
When we know things are cheap or on sale, we tend to buy more of them. If the latest $1,000 smartphone goes on sale for $99, we may buy one for all our family members and friends because, at that price, it’s a no-brainer. With stocks, it is harder to know when they are “on sale,” and there are hardly any “no-brainer” moments.
Dollar-cost averaging helps take the guesswork out of having to monitor the price of assets like stocks on a daily basis to determine when to buy them.
What is dollar-cost averaging?
Dollar-cost averaging is the process of investing your money in equal amounts and at regular intervals. For example, you could invest $100 monthly. By planning a fixed-dollar amount and a regular interval in advance, regardless of the price, you will typically buy more shares when prices are lower and buy fewer when prices rise. Through dollar-cost averaging, you can build your position on a consistent basis.
Consider an exchange-traded fund (ETF) consisting of U.S. stocks. Over time, the price of the ETF will rise and fall with the general movement of the stock market. Using dollar-cost averaging, you buy $100 of that ETF each month. If the ETF’s price goes higher, your $100 buys fewer shares, and if the ETF’s price falls, your $100 buys more shares. Using this process, you buy fewer of the more expensive shares and more of the cheaper shares.
The first step is to set up a dollar-cost averaging strategy by deciding how much you can invest and at what frequency. Once you start, stick to your schedule and keep investing. Here’s how:
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Periodic purchase
One of the more well-known strategies of dollar-cost averaging is what we outlined above, called periodic purchasing, which can be done in two ways:
- Set dollar amount: This strategy allocates a dollar amount, so in our case, $100 monthly. This amount is invested into the chosen asset every month regardless of what the market may be doing at the time. This strategy may be suitable for those who have a set amount of funds to dedicate to investing every month, as there will never be any fluctuations in how much is invested.
- Set asset amount: This strategy allocates an asset amount, let’s say 200 shares monthly. That amount will be purchased every month at market price, regardless of what the market conditions may be at the time. This strategy may be suitable for those looking to acquire a set number of shares over time without drastically affecting their price, or those who don’t mind having a potentially variable investment amount month-to-month.
Scale orders
Another strategy to acquire more shares of an asset while potentially lowering your average acquisition cost might be to use scale orders. Scale orders are limit orders that come into effect as a stock starts to decline in price, with new buy orders triggered for each decline. For instance, you might set up several limit orders to purchase 100 units for every 25-cent decline in price. This strategy is likely to lower your cost basis but may also require timing the market for best results, which is very hard to get right.
Is dollar-cost averaging right for you?
When considering whether dollar-cost averaging is the right strategy for you, it typically helps to examine the pros and cons and then assess them against your own preferences and circumstances.
Potential benefits of dollar-cost averaging
Here are some of the potential upsides of dollar-cost averaging:
- Reduced risk of poor market timing: Since dollar-cost averaging is all about making pre-set purchases at specific intervals regardless of how the market is performing, there’s a lower potential risk of buying shares at the wrong time and potentially “missing out” on a good deal. Regular, periodic investments may help you to take advantage of the good times and weather the storm through bad ones.
- Possibility for a lower average acquisition price: Since you’re able to buy more shares when prices are down, it may be possible for you to lower your overall acquisition price using dollar-cost averaging over time. Additionally, scale orders may help you get there in even less time.
- Reduced emotional susceptibility to market changes: Since your investments are on a schedule, with set dollar or asset amounts for each purchase, there’s less room for impulsive decision-making. A few potentially down weeks in the market may have other investors spelling doom and gloom as they abandon their positions. With dollar-cost averaging, however, those moments of crisis are less troublesome – your investments will proceed as scheduled, possibly even picking some shares up at a discounted price.
Potential downsides of dollar-cost averaging
Dollar-cost averaging may be a worthwhile investing strategy for many, but it still has some cons that may not make it ideal for you. Here are some of the potential downsides to consider:
- Reduced flexibility to act on market conditions: Since your investments are made on a set schedule, dollar-cost averaging may not leave a lot of room for responding to market conditions and jumping on an opportunity. In this case, you may find yourself having to choose what to put your money toward – especially if you only have a set amount for your investments every month.
- Potential for lower returns: Since dollar-cost averaging doesn’t try to time the market, there’s a possibility that your returns might be lower than a well-timed lump-sum investment. Risk and reward often go hand in hand when it comes to investing, so there’s always the possibility (however big or small) that a risky bet pays out big.
Choosing your investment vehicles
Although you can potentially use dollar-cost averaging with a wide range of investment and asset types, it’s often associated with investing in individual stocks, mutual funds or ETFs. Assets like mutual funds and ETFs offer diversification across a wide range of securities, which might make them more suitable for long-term investment goals.
It should also be noted that, like any investment, dollar-cost averaging requires the underlying asset to grow over time to provide any actual return. If the underlying business or asset is in decline, it’s still likely to be a bad investment. Consider speaking with a financial specialist or professional to learn more.
The bottom line
Dollar-cost averaging is a useful way to steadily increase your holdings of one or more assets like stocks, mutual funds or ETFs at a steady rate, helping to smooth out market fluctuations while sticking to a set amount invested at a set schedule (typically monthly). Speaking with a financial professional may help you better understand how to best implement this strategy for your portfolio.
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Editorial staff, J.P. Morgan Wealth Management
