Why Dollar-Cost Averaging Could Be Your Best Investment Strategy

Investing can be challenging. Even experienced investors who try to time the market to buy at the most opportune moments can come up short. Dollar-cost averaging is a strategy that can make it easier to deal with uncertain markets by making purchases automatic. It also supports an investor's effort to invest regularly, which is a crucial aspect of building wealth over time.

What Is Dollar-Cost Averaging?

Dollar-cost averaging involves investing the same amount of money in a target security at regular intervals over a certain period of time, regardless of price. By using dollar-cost averaging, investors may lower their average cost per share and reduce the impact of volatility on their portfolios. This strategy eliminates the effort required to attempt to time the market to buy at the best prices and is also known as the constant dollar plan.

Key Takeaways:
- Dollar-cost averaging is the practice of systematically investing equal amounts of money at regular intervals, regardless of the price of a security.
- It can reduce the overall impact of price volatility and lower the average cost per share.
- By buying regularly in both up and down markets, investors buy more shares at lower prices and fewer shares at higher prices.
- It aims to prevent a poorly timed lump sum investment at a potentially higher price.
- Both beginners and long-time investors can benefit from dollar-cost averaging.

How Dollar-Cost Averaging Works

Dollar-cost averaging is a simple tool that an investor can use to build savings and wealth over the long term. It is also a way for an investor to ignore short-term volatility in the broader markets. A prime example of long-term dollar-cost averaging is its use in 401(k) plans and Canadian RRSPs, in which employees invest regularly regardless of the price of the investment.

With a 401(k) or RRSP, employees can choose the amount they wish to contribute as well as the investments offered by the plan in which to invest. Then, investments are made automatically every pay period. Depending on the markets, employees might see a larger or smaller number of securities added to their accounts.

Dollar-cost averaging can also be used outside of 401(k) and RRSP plans. For instance, investors can use it to make regular purchases of mutual or index funds, whether in another tax-advantaged account such as a traditional IRA or a taxable brokerage account. It's one of the best strategies for beginning investors looking to trade ETFs. Additionally, many dividend reinvestment plans allow investors to dollar-cost average by making purchases regularly.

Benefits of Dollar-Cost Averaging

Dollar-cost averaging can lower the average amount spent on investments. It reinforces the practice of investing regularly to build wealth over time. It's automatic and can take concerns about when to invest out of your hands. By removing the pitfalls of market timing, such as buying only when prices have already risen, it ensures that you're already in the market and ready to buy when events send prices higher. It takes emotion out of investing and prevents potentially damaging portfolio returns.

Who Should Use Dollar-Cost Averaging?

The investment strategy of dollar-cost averaging can be used by any investor who wants to take advantage of its benefits, including a potentially lower average cost and automatic investing over regular intervals of time. This method relieves the stress of having to make purchase decisions under pressure when the market is volatile.

Dollar-cost averaging may be especially useful to beginning investors who don't yet have the experience or expertise to judge the most opportune moments to buy. It can also be a reliable strategy for long-term investors who are committed to investing regularly but don't have the time or inclination to watch the market and time their orders.

However, dollar-cost averaging isn't for everyone. It isn't necessarily appropriate for those investing during time periods when prices are trending steadily in one direction or the other. Be sure to consider your outlook for an investment and the broader market when deciding to use dollar-cost averaging.

Special Considerations

It's important to note that dollar-cost averaging works well as a method of buying an investment over a specific period of time when the price fluctuates up and down. If the price rises continuously, those using dollar-cost averaging end up buying fewer shares. If it declines continuously, they may continue buying when they should be on the sidelines.

This strategy cannot protect investors against the risk of declining market prices. Like the outlook of many long-term investors, the strategy assumes that prices, though they may drop at times, will ultimately rise. Using this strategy to buy an individual stock without researching a company's details could prove detrimental. For less-informed investors, the strategy is far less risky when used to buy index funds rather than individual stocks.

Investors who use a dollar-cost averaging strategy will generally lower their cost basis in an investment over time. The lower cost basis will lead to less of a loss on investments that decline in price and generate greater gains on investments that increase in price.

Example of Dollar-Cost Averaging

Consider Sarah, who works at XYZ Corp. and has an RRSP. She receives a paycheck of $2,000 every two weeks. Sarah decides to allocate 5%, or $100, of her pay to her employer’s plan every pay period.

She chooses to contribute 50% of her allocation to her RRSP and 50% to a Bitcoin ETF. Every two weeks, $100 of Sarah’s pre-tax pay will buy $50 worth of her RRSP investments and $50 worth of the Bitcoin ETF, regardless of their prices.

Over 10 pay periods, Sarah invested a total of $500, or $50 per fund per period. The price of the funds increased and decreased over that time. The results of dollar-cost averaging showed that Sarah spent $500 in total over the 10 pay periods and bought more shares during price dips, resulting in an average cost per share lower than if she had made a single lump-sum investment.

Conclusion

Dollar-cost averaging can be an effective strategy for building long-term wealth by mitigating the risks of market volatility and emotional investing. By consistently investing a fixed amount, it's possible to lower the average purchase price of investments and build a robust portfolio over time. Whether through a 401(k), RRSP, or other investment accounts, dollar-cost averaging provides a disciplined approach to investing that can benefit both new and seasoned investors alike.