Dollar-cost averagingDollar-cost averaging A strategy where you try to reduce the cost of buying securities by spreading your purchases out over time. You buy a set amount of a security, such as a mutual fund, at regular intervals. In the end, you average out your cost per unit.+ read full definition is investing the same amount of money at regular intervals. For example, you may choose to invest $100 every two weeks from your paycheque.
This strategy could be useful if you’re worried about market volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition. By spreading out your investment purchases, you can avoid committing all your money to buying an investment at one time. You may reduce the impact of timing risk, the probability of buying an investment just before its value declines.
Dollar-cost averaging can be automated. You can schedule investment purchases on a specific date every week or month. You can also time it with your pay schedule.
3 advantages of dollar-cost averaging
1. Reduced risk
In spreading out your investing intervals, you are also spreading out your investment risk. The cost of your investment averages out over time as you buy at high and low prices. If the value of the investment were to decline, the decrease could be less compared to if you invested a lump-sum amount at a high price.
Since you’re investing at regular intervals, regardless of whether prices are up or down, there’s no need to time the market or think about when the optimal time is to invest. This could be ideal if you have a longer investing horizon.
You can set aside small amounts each month for investing if you have other financial priorities like paying rent or student loans. You can reach your investing goals in time while staying within your budgetBudget A monthly or yearly estimated plan for spending and saving. You work it out based on your income and expenses.+ read full definition.
3 disadvantages of dollar-cost averaging
1. Lower returns
In the long-run, you may receive less returns on your investment compared to investing a lump-sum amount. By spreading out your investment purchases, only some of your funds will benefit from being invested early. You may miss out on capital gains, interest or dividends.
2. Increased costs
Since you’re making multiple investment purchases over a period of time, you may incur more trading or transaction costs compared to investing a one-time, lump-sum amount.
3. Missed opportunities
There could be situations where it would be advantageous to invest a larger amount, such as if you anticipate prices to increase soon. However, with dollar-cost averaging, you only commit a fixed dollar amount at each investing interval.