Is Dollar-Cost Averaging a Good Strategy for You?

By: Vidalia Cornwall

Is Dollar-cost averaging the answer to volatile times?

If you’ve been investing for a while, you may have heard about a strategy called “dollar-cost averaging.” It’s a term that gets thrown around a lot, but what does it actually mean and should you use it?

What Is Dollar-Cost Averaging?

Dollar-cost averaging means investing a fixed dollar amount at regular intervals over a period of time. As the market fluctuates, the same dollars will buy more or fewer shares of the investment depending on the price. For example, if you invest $1,000 in March when the price of a stock is $100, you’ll buy 10 shares. But if at your next regular contribution in April the price has decreased to $80, you’ll be able to buy 12.5 shares. Over time, the number of shares you own will reflect an average price, rather than the price of the stock on any single given day.

If you participate in a retirement plan at work, you’re likely already using a form of dollar-cost averaging. With each paycheck, the portion you set aside for retirement is purchasing your investments, resulting in an average price over time. This set-it-and-forget-it strategy works well for 401(k)s and other retirement accounts, as contributing over time is logistically and financially easier than doing a larger contribution once a year.

But what happens if you have a lump sum of cash on the sidelines? Maybe you sold RSUs and haven’t reinvested the proceeds yet, or maybe you’ve been saving in cash and want to put your money to work. Should you dollar-cost average or invest it all at once?

Dollar-Cost Averaging Can Be Helpful…

Dollar-cost averaging can be psychologically appealing, especially if you’re considering a large sum of money. If you invest $1,000 in a lump sum and the stock market immediately dips 20%, you’re only down $200 — but if you’re considering an investment of $100,000, that’s $20,000 “gone.” While we as investors may know intellectually that the market is likely to rebound based on historical results, that doesn’t make the drop in your account balance any less painful in the moment.  That’s why it’s crucial to align your investments with your goals. You should only expose your funds to volatile assets when you don’t plan to need them for at least a few years, if not longer. It’s also important - but not easy - to manage emotions in investing. Working with a financial planner can help with both of these tasks.

Given historical patterns of returns, holding excessive amounts of cash is unlikely to help you reach your goals. So if your decision is between keeping the entire sum in cash while you wait for the “perfect” time to invest or dollar-cost averaging into the market, dollar-cost averaging may be a helpful solution to consider.

…But is Technically Suboptimal

While dollar-cost averaging may help with overcoming hesitancy and our human tendency towards loss aversion, investing your excess cash in a lump sum is likely the better strategy. Before digging into the research, let’s consider the reasoning behind this. When you wait to invest money into the market, you’re essentially predicting that now isn’t the best time to buy because you think the market will go down soon. Sometimes, that prediction will be correct. But what if it’s wrong, and the market goes up during the period that you’re dollar-cost averaging? In that case, you’d have missed out on gains by holding money on the sidelines instead of just investing all at once. Since the stock market has gone up over time, you’re more likely to miss gains than avoid losses by dollar-cost-averaging.

Pro Tip: You’re more likely to miss gains than avoid losses by dollar-cost-averaging.

No one can know for sure which scenario will happen in your specific case. Trying to predict (or “time”) the market is an unreliable and typically inferior investment strategy. But what we can do is look at averages to see which strategy would work better in most cases.

Researchers at Morningstar conducted a study comparing dollar-cost averaging (DCA) to lump-sum investing (LSI) into an index tracking large US companies. They considered scenarios over periods of time ranging from 2 months to 10 years. As shown in the graph below, dollar-cost averaging underperformed in a majority of scenarios across each period tested. Spreading out investments over 10 months underperformed lump-sum investing in 72% of scenarios, and over 10 years, it underperformed in over 90% of scenarios. Even in the notably volatile year of 2008, lump-sum investing would have produced better returns. The data is clear: assuming markets continue to provide positive returns over most time periods, dollar-cost averaging isn’t an optimal strategy.

Finding a Warmer Lake

On a recent Morningstar podcast, the hosts compared dollar-cost averaging to the idea of gradually entering a cold lake. Most of the time, we feel more comfortable just dipping our toes in and gradually submerging into the lake, even though stepping in all at once can make it easier for our bodies to acclimatize to the colder temperature. If jumping in at once (lump sum investing) makes you too uncomfortable, you may just need to find a warmer lake - or a less risky portfolio! 

For example, if knowing the potential volatility associated with a 90% stock portfolio makes you hesitant to invest all at once, you may need to find a less risky portfolio to ensure the allocation aligns with the goal for the account. Ideally, you should be comfortable enough to invest a lump sum now and keep it there over the long term (3-5 years or longer), whether that portfolio has 90% in stocks or 40%. As the old saying goes, it’s not so much about timing the market as it is time in the market. Whatever strategy enables you to keep your money invested and working towards your goals for the longest period of time is going to be the best option.

If you are unsure of which strategy is right for you, please don’t hesitate to reach out.

Team Spotlight:

Vidalia Cornwall, RICPⓇ

Vidalia joined the Ballast Point team in November 2022. She currently lives in Northern Utah but will be moving to the Upper Peninsula of Michigan in December for her husband, Chaz, to pursue a Ph.D. in Electrical Engineering at Michigan Tech. She enjoys spending time outside, baking, and good books, and just completed her first marathon this year. 

Vidalia passed the CFP exam in March 2021 and is excited to finish her experience requirement and become a full-fledged CFP in 2023.