How to invest using dollar-cost averaging

 Dollar cost averaging (DCA) is an investment strategy that aims to apply value investing principles to regular investment. The term was first coined by Benjamin Graham in his book The Intelligent Investor.

You might already be engaging in dollar-cost averaging and not even know it. If you have a 401(k) or another type of defined contribution plan, your contributions are allocated to one or more investment options on a regular, fixed schedule, regardless of what the market is doing. Every time this happens you are dollar-cost averaging.

Dollar-cost averaging works because it minimizes risk and removes some of the emotional stress that comes with investing. Instead of purchasing shares at a single price point, with dollar-cost averaging you buy in smaller amounts at regular intervals, regardless of price. It works best in bear markets and with securities that have dramatic price swings up and down. It is those times, and those types of investments, where reducing investor anxiety and fear of missing out tend to be the most important.

Is dollar-cost averaging a good way to invest?

Dollar-cost averaging is a good strategy for investors with lower risk tolerance since putting a lump sum of money into the market all at once can run the risk of buying at a peak, which can be unsettling if prices fall. Value averaging aims to invest more when the share price falls and less when the share price rises.

It would be great if we could buy stocks, or other types of investments, when the market is low and sell when the market is high. This sounds easy enough, in theory. In practice, it’s almost impossible—even for professional stock pickers—to determine how the market will move over the short term. Today’s low could be a relatively high price next week or next month.

What are the potential downsides of dollar-cost averaging?

A disadvantage of dollar-cost averaging is that the market tends to go up over time. In fact, research from the Financial Planning Association and Vanguard has found that over the very long term, dollar-cost averaging can underperform lump sum investing. The longer the time frame, the greater the chance that investing all at once beat dollar-cost averaging, the study found. Of course, this doesn’t apply to something like your 401(k), because in that situation, you are investing the money as you earn it – not holding money in cash until a later date.

What’s the bottom line for investors?

As is the case in all aspects of investing, it’s important to consider potential returns as well as your tolerance for risk. Investing all of your money right away might yield higher returns than dribbling out smaller amounts over time. But if you’re looking to reduce your risk and control your emotions, or you fear that the market is heading for drop, then dollar-cost averaging could be a viable strategy – even if that means forfeiting some potential upside. You might consider how you would feel if you invested all of your bonus at one time and the market swooned soon after.