Dollar-cost averaging is buying a fixed dollar amount of an investment periodically without concern for the prevailing market price of that investment.
If you plan to invest regularly, your options are to invest occasionally according to a price target — what you want to pay for an investment — or to invest steadily regardless of current prices.
The first approach could be called market timing. It implies that you know something about the relative value of the investment and can judge whether the market price that day is reasonable.
The second is dollar-cost averaging. You are not concerned about the price today, tomorrow or in the future because your generally believe that over long periods of time it won’t matter.
In fact, you believe that buying fixed amounts at regular intervals will increase your chances of purchasing more of the investment at favorable prices and less at unfavorable price and do so automatically.
The problem with buying a lot of an investment at once is that you might choose to invest on a day when the investment was greatly overpriced by the rest of the market.
For instance, you decide to buy a stock that has traded at around $50 a share for a few years. On the day you buy, however, some news about the company breaks and you manage to buy it at $65 a share. Oops.
Pretty soon, the stock is back trading at $50 and you are in the hole for $15, for a long while perhaps.
This could, of course, work the other way. You might accidentally get a better-than-expected price on the same stock, say $40 a share on the day you happen to buy.
Dollar-cost averaging smooths out this risk by getting you into a position at regular intervals. Instead of buying $1,200 of a stock or mutual fund on January 1, you might invest $100 a month for a year.
Over the course of those 12 months, you are likely to find that you bought at the $50 price or near it, on average. You thus would expect to buy two shares a month and own 24 shares by year-end of that investment.
But what really happens? On the months where the price was below the long-term average, your $100 bought more than two shares. Let’s say 2.3 shares.
On months where the price was above the average, of course, you get fewer than two shares. Perhaps 1.7 shares on those months.
Over time, you tend to get more shares for your dollars when the price is lower (remember, it generally rises over time). That lowers your overall “get in” price on the investment.
Will you beat the market by using dollar-cost averaging? No, of course not. But since the overall trend of the investment markets is to appreciate in value, every chance you get to invest at a lower price helps your long-term return.
Rather, the value of dollar-cost averaging to the serious investor is that it greatly minimizes the risk of emotional decision-making. For instance, a series of news events about an election, a war or the economy itself might cause you to invest or not invest based on your expectations of an outcome.
Short-term political and economic events, however, are notoriously bad guides for investment decisions. You might be right and make money, but you might be wrong and lose your shirt, too.
Dollar-cost averaging keeps your investment process predictable and on schedule while reducing these emotional risks that can cost you a lot of money down the road, when it matters.