By Margaret Jackson

Copyright benzinga

For investors who want a simple strategy to lower risk and smooth out the ups and downs of the market, dollar-cost averaging is a great option to consider.

With dollar-cost averaging, you buy a fixed dollar amount of a particular investment, such as a stock or an exchange-traded fund (ETF), at regular intervals.

This disciplined approach means you buy more shares when the price is low and fewer shares when the price is high, effectively averaging out your purchase price over time.

In this article, we’ll explore what dollar-cost averaging is, how it works to reduce risk and when it might be the most effective strategy for building wealth.

The Main Concept Explained

With dollar-cost averaging, you invest a set amount of money at regular intervals, regardless of market conditions. Instead of making a single, large lump-sum investment, you spread your purchases out over weeks, months or years.

The strategy is popular with investors who want to avoid the risk of buying at a market peak. It automates the process of buying low and high, ensuring you don’t try to time the market, which is difficult even for professional investors.

Let’s say you have $12,000 to invest. With a lump-sum strategy, you’d invest it all at once. With dollar-cost averaging, you might invest $1,000 every month for 12 months. The regular and consistent investment is the core of the dollar-cost averaging strategy.

How it Works

The magic of dollar-cost averaging is how it handles market volatility. Let’s look at an example with a hypothetical stock.

Suppose you invest $100 every month.

Month 1: The stock price is $10 per share. You buy 10 shares.Month 2: The stock price drops to $8 per share. You buy 12.5 shares. Month 3: The stock price rises to $12.50 per share. You buy eight shares.

After three months, you’ve invested $300 and own 30.5 shares. Your average cost per share is $9.84. It’s lower than the initial price of $10, demonstrating how dollar-cost averaging allows you to acquire more shares during market dips, lowering your overall average cost.

Reduces risk and mitigates volatility: By not investing all your money at once, you avoid the potential of a large loss if the market drops shortly after your investment. It helps smooth out the ups and downs of the market.Builds discipline: Dollar-cost averaging encourages a consistent, long-term approach. It removes the emotional element of trying to time the market and promotes saving regularly.Easily automated: Many platforms allow you to set up automatic, recurring investments, making it a set-it-and-forget-it strategy. You may also have the option of buying fractional shares which simplifies the process by allowing you to invest a flat amount, such as $100, on a regular basis.

May underperform in bull markets: If the market is consistently rising, a lump-sum investment would likely outperform dollar-cost averaging. This is because a lump-sum investor gets all their money into the market earlier, benefiting from the full growth.Higher transaction costs: While less of a concern with today’s zero-commission trading, making multiple small transactions is sometimes more expensive than one large one.

A Tale of Two Strategies

Let’s look at two hypothetical scenarios with two investors, Bob and Jane, who each have $12,000 to invest in the S&P 500 over a 12-month period.

Bob, the lump-sum investor, puts all his money into the market at once on Jan. 1 when the index is at 4,000. This buys him three shares.

Jane uses the dollar-cost averaging strategy to invest $1,000 every month. Throughout the year, the index fluctuates but generally rises, starting at 4,000 and ending at 4,400. Jane’s consistent investments mean she buys more shares when the price is lower, for instance during a month when the index is 3,600, and fewer shares when the price is higher.

At the end of the year, when the index is at 4,400, Bob’s three shares are worth $13,200. Jane has only acquired 2.97 shares through her monthly investments, which are not worth about $13,068. In this scenario, Bob’s strategy produced better returns.

If the market is declining, however, dollar-cost averaging may win out. Bob and Jane both have the same $12,000 to invest over 12 months. Bob, the lump-sum investor, puts all his money in the market on Jan. 1 when the market is at 4,000. Jane, the dollar-cost averaging investors, invests $1,000 on the first of every month.

The market experiences a sustained decline throughout the year, with the index falling from 4,000 in January to 1,800 in December. Bob’s initial investment of three shares is significantly devalued — worth only $5,400 by the final index value, representing a loss of $6,600.

Jane, on the other hand, benefits from the falling market. Her consistent monthly investments allow her to buy more shares as the price drops. For instance, she buys 0.25 shares in January but acquires 0.56 shares in December for the same $1,000.

By the end of the year, Jane has accumulated 4.09 shares, making her investment worth about $7,362. Although it’s a loss of $4,638 dollars, it’s significantly less than Bob’s loss.

A Practical Path to Building Wealth

Dollar-cost averaging helps investors navigate market volatility by removing the pressure of perfect timing. It encourages consistent investing over time, allowing you to buy more shares when prices are low and fewer when they are high.

While historical data suggests that lump-sum investing often outperforms dollar-cost averaging, dollar-cost averaging is a powerful tool for building financial discipline and mitigating the risk of investing all your capital at a market peak.

For a beginner investor or someone with a regular income stream to invest, dollar-cost averaging is a practical approach to building a diversified portfolio for the long term.