Under the lump sum method, the investor purchased 24 shares in January, so the investment value in June was $513 (24 shares times $21.38 per share). The investment decreased 14.5%.
With dollar-cost averaging—as the mutual fund declined below its January share price—each month’s $100 investment bought more than four shares on average. After six months, the investor accumulated 26.20 shares, and the investment was worth $560.16 (26.20 shares times June’s $21.38 share price.) The investment is down only 6.64%.
Does Market Timing Work?
Instead of consistent buying, some investors get drawn into timing the bottom or dips in the market.
Academic research in finance has proved that trying to time the market accurately is nearly impossible. Berkshire Hathaway Chairman and CEO Warren Buffett gave his take on market timing during the company’s 2022 shareholders’ meeting in April.
Attempting to predict a decline, let alone the end of a drop, is very difficult.
Dollar-Cost Averaging Versus Buying the Dip
The strategy of “buying the dip” attempts to pinpoint market downturns. Here, an investor builds up money to invest, but keeps it in cash and invests it only when the price of an investment declines (dips) from a recent high.
If an investor could accurately predict dips, would it not be better to just buy the dip?
A recent analysis looked at returns for a person with a 40-year time horizon who could time market bottoms perfectly. If they started investing in the S&P 500® anytime between 1920–1980, dollar-cost averaging would still outperform buying the dip 70% of the time.² When the investor’s accuracy was reduced, and they invested within two months of the actual bottom, the strategy underperformed 97% of the time.³ It’s worth noting that neither method will save you from losses if the investment declines in value over your investment time horizon. But when looking at strategies for investing, you typically will do so in investments that you think will rise over time.
Why did consistent investing outperform?
The Power of Compounding
While waiting for the dip, the investor is building cash on the sidelines that does not benefit from making investment returns.
Historically, the market can go several months and even years without experiencing a decline large enough to be considered a dip. Missing just a handful of days in the market can drastically reduce an investor’s average returns over time.
Staying in the market and putting your investments to work systematically captures one of the most important aspects of long-term investing—compounding.
Automatic Investing Tames Emotions and Simplifies Decisions
Dollar-cost averaging lends itself practically to the investment process. By taking the investment decision off of the investor’s plate—much like what’s done with contributing to a 401(k)—an investor can easily stick to an investment plan.
Breaking down the purchase of investments into several smaller blocks also greatly reduces the risk of regret from ill-timed purchases. When the market falls, you can be happy to add to your investments at lower prices, and when the market rises, you can be happy that you got in at lower prices.
FAQs
When dollar-cost averaging, you invest the same amount at regular intervals and by doing so, hopefully lower your average purchase price. You will already be in the market when prices drop and when they rise. For instance, you'll have exposure to dips when they happen and don't have to try to time them.
Does dollar-cost averaging actually work? ›
In a market with major price swings, dollar-cost averaging can be particularly useful, in part because it allows you to ignore the emotional highs and lows of watching the market and trying to time your trades perfectly. When prices are down, your set investment buys more shares; when they are up, you get fewer shares.
Can you automate dollar-cost averaging? ›
You can take advantage of the benefits of dollar cost averaging by setting up automated contributions to your Schwab Intelligent Portfolios account.
Why i don t recommend dollar-cost averaging? ›
Dollar cost averaging is an investment strategy that can help mitigate the impact of short-term volatility and take the emotion out of investing. However, it could cause you to miss out on certain opportunities, and it could also result in fewer shares purchased over time.
What are the two drawbacks to dollar-cost averaging? ›
Key takeaways
- Dollar-cost averaging can help you manage risk.
- This strategy involves making regular investments with the same or similar amount of money each time.
- It does not prevent losses, and it may lead to forgoing some return potential.
Dollar-cost averaging allows you to manage some risk on entry, but lump-sum investing, plus portfolio management strategies like rebalancing, may provide the best of both worlds: putting money to work more quickly along with risk management throughout the lifetime of your investments.
How do you make dollar-cost averaging work for you? ›
The strategy couldn't be simpler. Invest the same amount of money in the same stock or mutual fund at regular intervals, say monthly. Ignore the fluctuations in the price of your investment. Whether it's up or down, you're putting the same amount of money into it.
Should I DCA weekly or monthly? ›
Investment goals: Your time horizon is crucial. If you're aiming for long-term growth, a monthly DCA might suit you, allowing you to ride out short-term market fluctuations. In contrast, if you're after short-term profits, a weekly or bi-weekly DCA can help you take advantage of quicker market movements.
What is the best frequency for dollar-cost averaging? ›
Most investors prefer the monthly dollar cost averaging method. This is a more familiar frequency to those used to a SIPP plan where funds are taken directly from your salary and invested into your investment account.
Is it better to invest weekly or monthly? ›
A year has 52 weeks and only 12 months. So if you invest monthly, you invest $12k a year. If you invest weekly, you invest $13k a year. Here the weekly approach wins clearly with a 7.89% advantage.
Reverse dollar-cost averaging is the opposite of dollar-cost averaging—taking the same amount of money out of investments at regular intervals. For retirees, you'll likely need to withdraw from investments regularly to cover monthly expenses.
Is dollar-cost averaging better than buying the dip? ›
Buying the dip only works if you know that you've reached the bottom of a decline, and you can time it perfectly. What's more, severe dips—where you stand to get huge returns—are rare events. Therefore, the strategy rarely beats dollar-cost averaging.
Under what circ*mstances is dollar-cost averaging least likely to be effective? ›
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. So, the strategy cannot protect investors against the risk of declining market prices.
Does dollar-cost averaging always work? ›
In the Financial Planning Association's and Vanguard's research, investors who used dollar cost averaging did see significant investment growth—just slightly less most of the time than if they had invested a lump sum. Also, keep in mind that lump sum investing only beat dollar cost averaging most of the time.
Is dollar-cost averaging good for retirement? ›
There is also a lesser known but very helpful investment strategy called dollar cost averaging. This approach works well with regular contributions, like the ones you make to a 401(k), and can help you improve your investments over time.
What is dynamic dollar-cost averaging? ›
"Dollar cost averaging" aims to reduce the risk associated with timing a single lump sum investment. Each week for one year, 1/52 of initial investment is transferred into the Dynamic Fund(s) as pre-selected from a list of eligible funds.
Is DCA a good strategy? ›
Dollar-Cost Averaging
DCA is a good strategy for investors with lower risk tolerance. Investors who put a lump sum of money into the market at once, run the risk of buying at a peak, which can be unsettling if prices fall. The potential for this price drop is called a timing risk.
Is lump sum or DCA better? ›
Lump Sum historically provides better returns in stocks, bonds and the traditional 60/40 mix, according to research from the CFA Institute. The sooner one enters the market typically the better the results, but not always since market swings can negatively impact Lump Sum.
What is dollar-cost averaging used to avoid buying? ›
By committing to a dollar-cost averaging approach, investors avoid the risk that they will make counter-productive decisions out of greed or fear, such as buying more when prices are rising or panic-selling when prices decline.
