What to Know About Dollar-Cost Averaging
"Called my nigga and told him, 'Mane, I'm finna spend $6 million on stocks'" - Young Dolph, "Sunshine"
Many people who want to begin investing struggle with deciding the "perfect time" to start (hint: there's no such thing). If you're trying to time the market to buy investments at the lowest possible price, you're already fighting an uphill battle.
One of the best strategies to follow when deciding when to invest is dollar-cost averaging. Its goal is to help take some of the emotions out of investing, stop you from trying to time the market, and focus on your long-term goals.
Learn more about how it works and how you can apply it.
Dollar-Cost Averaging
Dollar-cost averaging involves investing specific amounts of money at regular intervals, regardless of the stock price at the time. Let's examine the above quote from Young Dolph. First and foremost, it must be nice to wake up and decide you want to put $6 million into the stock market that day.
Now, instead of investing all $6 million at once, Dolph might decide to follow the dollar-cost averaging strategy and invest the money over intervals. Below are some scenarios he might consider:
Weekly: $115,385 ($6 million / 52)
Monthly: $500,000 ($6 million / 12)
Quarterly: $1.5 million ($6 million / 4)
Bi-annually: $3 million ($6 million / 2)
If he decides to dollar-cost average and does it quarterly, no matter what the price is of the stocks he buys, he would spend $1.5 million on them; if he decides he'll do it on the 1st of every month, he'll spend $500,000 each time.
Of course, these numbers are extravagant, and I don't expect you to be plotting on dropping a mansion in Atlanta every month on stocks, but anybody with the means to invest can use the dollar-cost averaging strategy—no matter how small the number.
If you decide you want to take advantage of a Roth IRA (which you should) and contribute the $6,000 yearly maximum, you might decide to put $500 into the account on a specific day of each month or put $1,500 into it on the last day of each quarter.
With many platforms now offering fractional shares, you could even decide to do $5–$20 weekly or every paycheck. Getting started is more important than how much you start with.
The frequency you invest doesn't matter; what matters is that you remain consistent.
The Purpose of Dollar-Cost Averaging
Dollar-cost averaging is meant to help someone avoid making a big ass investment at once when stocks are at a high price point or overvalued. Let's examine three situations to see it in action:
Making one big ass investment
Dollar-cost averaging while the market is flat-ish
Dollar-cost averaging while the market is declining
Big Ass Investment
Imagine you have $5,000 that you want to invest in Company ABC. If Company ABC's stock price is $100 at the time, you'll get 50 shares. Here are your profits/losses if you decide to sell your shares at the following prices:
$80: $1,000 loss
$120: $1,000 profit
Dollar-Cost Averaging, Flat-ish Market
A flat market doesn't mean stock prices literally stay the same, but in general, it's relatively small up and down moves that essentially make it seem flat. Instead of one purchase at $100/share, suppose you split the $5,000 over four purchases at the following prices:
$100: 12.5 shares ($1,250 / $100)
$90: 13.9 shares ($1,250 / $90)
$110: 11.4 shares ($1,250 / $110)
$105: 11.9 shares ($1,250 / $105)
In this scenario, you would end up with 49.7 shares of Company ABC—damn near the same as the lump-sum scenario. The difference, though, is that you avoided the risk of mistiming the market and buying the stock when it was at its peak.
Hindsight is always 20/20. It's easy to look back and think it wouldn't matter which strategy you used in this case, but you can't predict what the market is going to do, and once you start thinking you can, you put yourself at risk of losing money.
If there was a guaranteed way to predict what the stock market was going to do, very few of us would be broke.
Dollar-Cost Averaging, Declining Market
Dollar-cost averaging in declining markets is like Michael Jordan in the NBA Finals: Undefeated. Instead of the big ass $5,000 investment at $100/share, let's say you split it into four purchases at the following prices:
$100: 12.5 shares ($1,250 / $100)
$90: 13.9 shares ($1,250 / $90)
$85: 14.7 shares ($1,250 / $85)
$75: 16.7 shares ($1,250 / $75)
In this scenario, you'd end up with 57.8 shares, almost eight more than a big ass purchase. Depending on when you sell your shares of Company ABC, those eight shares could be worth hundreds or thousands—all from the same $5,000. Here are your profit/losses compared to the big ass investment scenario, if you sold your shares at those same prices:
$80: -$376 loss ($624 less)
$120: $1,936 profit ($936 more)
$140: $3,092 profit ($1,092 more)
You're a lot better off in this scenario.
Who Should Dollar-Cost Average?
Anyone can benefit from dollar-cost averaging, but it's especially useful for long-term investors. If you're investing for the long run, you shouldn't be concerned with the daily changes in stock prices. If I know I'm holding on to a stock for years, there's no reason to care if it's $100 this week, $120 next week, then $90 the week after. What matters is that over time it grows.
Humans are naturally irrational (just take a look around), and investing is a prime example of that. Using the dollar-cost averaging strategy takes the emotion out of investing; y'all can be friends with benefits instead of in a "complicated" situation.
The downside of Dollar-Cost Averaging
The one downside to using dollar-cost averaging is that you miss the chance to make a big ass investment while stocks are at their lowest prices.
On March 23, 2020, the stock market reached its lowest point because of the pandemic. In the next 100 days, the stock market experienced a 50% rise—its biggest 100-day surge since 1933. Had you invested your $5,000 into the S&P 500 in March, you would've made around $2,500 by mid-August.
This only really matters if you want a short-term profit, though. If you're investing for the long-term, dollar-cost averaging is by far one of the better, if not the best, strategy to use.
401(k)'s are a common example of dollar-cost averaging. If you contribute to a 401(k), your job will invest the same amount each paycheck, regardless of the stock prices at the time.