What is dollar cost averaging?

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Steady does it.

© Volodymyr/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

Dollar cost averaging is an investment strategy in which you divide the total amount you’d like to invest into small increments over time, in hopes of lowering the average price, and aim for better returns in the long run.

Have you ever decided to fill your gas tank just halfway, hoping to come back in a day or two and get a few more gallons at a lower price? Like the price of gasoline, stocks go up, but they also sometimes sink. If you buy a stock or a stock fund in smaller batches over weeks, months, or years with a dollar cost averaging investment strategy, you’ll accumulate shares at a range of prices instead of just one.

In a market that’s falling, that means your investments over time might be cheaper on average than if you bought one large batch. Cheaper is better, provided it’s a quality stock that can bounce back. If the stock fluctuates, going up and down, you’ll buy fewer shares at higher prices and more shares at lower prices as you build your position. That can ultimately mean a better return on investment years later when you sell.

Dollar cost averaging can also be handy if you don’t have a huge chunk of cash ready to invest. Instead, you can build your position slowly, with smaller infusions over time.

Here’s how to dollar cost average:

You may be thinking, “Sure, but what if the stock goes up?” Well, if that happens, good for you. It was a solid investment. You’ll buy fewer shares at the higher price, simply because you spend the same amount each time. And you’ll gain from the stock’s gains, of course. The downside is you won’t gain as quickly as you would have if you bought all your shares at once. However, that might not have been an affordable option in the first place.

You might also think, “Why buy every month when I could just buy at the bottom?” That’s a common fallacy, unless you have a genuine crystal ball. Even expert investors have trouble “timing the market.” Dollar cost averaging keeps you in the market over time, and over the long haul that’s more important than trying to time a stock’s turnaround.

Let’s follow two investors, Bill and Ruth, to see how a dollar cost average investment strategy works. Suppose company XYZ is trading for $100 per share, but the price tends to be quite volatile, gyrating up and down around that $100 price.

By following the dollar cost averaging strategy, Ruth was able to buy 12.5 shares at $80 per share. She also bought 8.3 shares at $120. Doing the math, after 20 months, Ruth has acquired 208 shares [(12.5 x 10) + (8.3 x 10) = 208]. Ruth bought 8 shares more than Bill for the same cash. Her average price was lower, at $96.15 [(125 x 80) + (83 x 120) ÷ 208 = $96.15].

This example is an oversimplification, but it illustrates the power of dollar cost averaging. Over the course of 20 months, that same $20,000 investment allowed Ruth to purchase more shares than Bill at a lower average cost.

Do you participate in your employer’s 401(k) plan, making monthly contributions into one or several mutual funds or ETFs? Then you’re buying the same fund over time as it goes up and down, probably without thinking about it (except when you check your annual statement).

When you make regular contributions to a 401(k), you buy incrementally at a range of prices—sometimes low, sometimes high—and you get more shares when prices are lower. It sounds like a dollar cost averaging investment strategy, because it is.

In the context of a 401(k), dollar cost averaging has another advantage. Remember that old phrase, “Out of sight, out of mind”?

Your 401(k) takes the same amount from your paycheck automatically each month and drops it into whichever investments you’ve designated, whatever the current price might be. If the price weakens, you continue accumulating shares at the lower prices. Unless you actively monitor your account’s performance, you might not even notice the drop, which can prevent you from losing your head and selling out of fear.

If your employer doesn’t offer a 401(k), you can follow a dollar cost averaging strategy in your individual retirement account (IRA) instead.

One of the biggest mistakes you can make as an investor is to let fear guide your decisions. The best investors hunker down in tough times and execute their plan. If you’re using a dollar cost averaging strategy, it’s during those tough times you’ll accumulate more shares. Although past performance is no guarantee, historically, market recoveries tend to reward the persistent.

Warren Buffett once said he gets greedy when others are fearful, and fearful when others are greedy. We’re not encouraging greed, but Mr. Buffett was essentially saying that when accumulating investments, be more aggressive when prices are low and less aggressive when they’re high.

That’s dollar cost averaging in a nutshell.