What is dollar cost averaging? Think of it as a way to spread out risk when investing in stocks, bonds, or other equities. It keeps you from paying too much at any given time.
The way you make money in investments is by buying low and selling high, but you never know what the high and low points of the market will be. Dollar cost averaging helps you to avoid the highs.
How dollar cost averaging works
When you make a lump sum investment in one shot, you buy a bunch of stocks and bonds and hope for the best. You probably won’t buy on a day like October 11, 2007 or August 25, 1987, which were the high points before a stock market crash. But that’s a worst case scenario. If you invested your life savings on those days, it took about four years to make your money back.
It’s better to invest smaller amounts over time. Here’s why.
Let’s take the Fidelity Total Market Index Fund as an example. Over the course of 2019, its price ranged from $67.65 a share to $90.85 a share. There’s no way to know in the moment that $67.65 is the lowest it’s going to be this year, or that $90.85 is the highest it will be. In fact, when it’s at $67.65 your instinct is probably going to tell you it’s going to go lower, and at $90.85 you’ll probably think it’ll keep going higher. Market volatility messes with your head.
So I’m much better off if I invest a smaller amount every week, two weeks, or every month. I may miss the high and the low entirely if I do that. But if I do hit the high, I missed it 11 other times if I invest monthly, or 25 other times if I invest every two weeks. Sometimes it’ll be high and sometimes it’ll be low, but the overall price I pay will be somewhere in the middle.
Spreading out your bets like this shields you from market fluctuations. If your average cost per share is $82, you have a 9% better return than if you bought in at $90.
An example return on investment
So let’s take that Fidelity Total Market Index fund as an example. To make things easy, we’ll assume you invest $1,000 in 2019, with the intention to sell it all in 2026. We will also assume you didn’t reinvest your dividends, because I can’t predict those and it makes the math easier. If you reinvest your dividends, the return will be slightly higher. Just keep that in mind.
The price peaked on December 26, 2019 at just under $90.85. So if you invested on that date, you ended up owning 11.007 shares in the fund.
Let’s say you were insanely lucky and figured out that the low would be $67.65 on January 3. If you invested on that date, you ended up owning 14.78 shares.
And if you played it safe and invested $19.23 every Friday (or Monday following a holiday), you ended up owning 12.319 shares in the fund and paying an average of $81.17 per share. So you didn’t quite end up in the middle, but you outperformed the worst-case scenario by more than $9.
Let’s fast-forward to 2026. It’s time to sell, and shares are trading at $172.96 each. That’s not unrealistic, as stocks tend to double in value every 7 years.
If you bought in at $90.85, your investment is worth $1,903.80. Not bad for having bad luck.
The insanely lucky guy who bought in at $67.65 has an investment worth $2,556.52. Not realistic.
If you used dollar cost averaging, your investment is worth $2,130.75. No luck needed. All it takes to get the better return is to be disciplined enough to invest every Friday.
Good news: Dollar cost averaging is built into your 401(K) plan
And here’s some good news. The way 401(K) plans work, with making withdrawals from every paycheck, dollar cost averaging is built in. If you get paid monthly, you make 12 investments a year. If you get paid every two weeks, you make 26. Investing on a regular, periodic basis and holding over long periods of time helps make stocks much safer to invest in.