What is dollar-cost averaging and how to use it

What is dollar-cost averaging?

Dollar-cost averaging is an investment strategy where you invest a fixed amount of money at regular intervals into a particular asset, regardless of its share price. This strategy aims to smooth market volatility and mitigate the risk of a sharp drawdown in your investment portfolio.

Rather than trying to time the market, this approach involves investing consistently regardless of market conditions. Whether you're interested in global technology companies, emerging markets or commodity sectors, dollar-cost averaging could remove the pressure of predicting when markets will rise or fall.

You can apply this strategy to various assets, including individual shares and exchange traded funds (ETFs). Many investors find it especially useful for retirement contributions, as it can potentially build wealth over time while simplifying the investment process.

The strategy also makes investing more accessible across different income and experience levels – from those just starting their investment journey to seasoned traders looking for a systematic approach to building positions.

Dollar-cost averaging in action

The below graph illustrates the price smoothing nature of dollar-cost averaging. Let’s assume the investor contributes $100 monthly into an ETF. By contributing regularly, despite market fluctuations, the investor can get a more favourable average cost.

This means that by the time the price returns to its original level, the investor would have profited from buying shares at a relatively lower price.

In the chart you’ll see that by the end of the year, the investor has made a profit of over $150 above their combined regular contributions.

The same principle applies when comparing dollar-cost averaging to a lump-sum approach. Had the investor decided to invest their total monies ($1200) as a lump sum at the beginning of the period, they would’ve made no money by December as the ETF price is $1.00 per share again. Yet, they would’ve experienced significant volatility throughout the year.

* For explanatory purposes only – past performance isn’t indicative of future results.

What are the benefits of dollar-cost averaging?

Less dependent on market timing

When you invest the same dollar amount regularly at set intervals, you buy more shares when prices drop and fewer when they rise. This averaging effect can help reduce your overall cost per share over time. Of course, this doesn't eliminate risk - you could still lose money if markets decline, and past performance isn't an indicator of future results.

Builds consistent investing habits

Dollar-cost averaging creates a disciplined routine for building your investment portfolio. By committing a fixed amount whether markets are rising or falling, you remove emotion from the process. This consistency could help you stay committed to long-term financial goals - though it requires discipline to maintain contributions, especially during downturns. Remember, regular investing doesn't guarantee returns or protect against losses.

Start with smaller amounts

Rather than waiting to accumulate a large sum, you begin building your portfolio immediately with whatever amount you can invest regularly. This could make the strategy valuable for new investors or anyone with limited initial capital who wants to access global markets. However, smaller regular investments mean you'll be exposed to market fluctuations over a longer period.

Reduces pressure to predict market movements

Market timing requires you to be right twice - when to buy and when to sell. Dollar-cost averaging eliminates the first decision entirely. You invest regularly regardless of market conditions, avoiding the stress of trying to predict short-term price movements. While this removes timing pressure, you'll still need to monitor your investments and make decisions about when to adjust your strategy.

Please note: While these benefits make dollar-cost averaging an attractive strategy, remember that all investing involves risk. You could still lose money if markets decline significantly and the strategy doesn't guarantee profits.

What are the risks of dollar-cost averaging?

Market risk remains present

While regular investing helps manage market fluctuations, it doesn't protect against losses. In declining markets, you could still see your portfolio value fall. The strategy only spreads your investment over time – it can't shield you from substantial market downturns.

Timing in rising markets

If markets trend upward consistently, dollar-cost averaging means you'll buy shares at progressively higher prices. Since markets tend to rise more often than they fall, a lump-sum investment made early in a strong bull market could potentially deliver better returns than spreading purchases over time.

Inflation erodes cash reserves

Dollar-cost averaging typically involves holding cash reserves that you gradually invest over time. Inflation continuously reduces the purchasing power of this uninvested cash, meaning the real value of your money diminishes while you wait to deploy it into the market.

Investment quality still matters

Dollar-cost averaging isn't a silver bullet that guarantees success. While it helps reduce average purchase prices and removes timing stress, your underlying investment choices must still be sound. Gradually investing in poor-quality assets will still likely result in losses – the strategy can't compensate for fundamentally weak investments.

Strategy effectiveness depends on consistency

The strategy only works if you maintain regular contributions regardless of market conditions. Many investors make the mistake of stopping contributions during market downturns - exactly when they should be buying more shares at lower prices. This behaviour can undermine the strategy's effectiveness.

Regular portfolio review remains important

While dollar-cost averaging promotes disciplined investing, you still need to review your portfolio regularly. Market changes or shifts in your personal financial situation may require adjustments to your investment approach or the assets you're buying.

How to get started with dollar-cost averaging

Choose your investment amount

Decide how much you can invest regularly – whether weekly, monthly or quarterly. Pick an amount you can maintain consistently without straining your finances. You can always increase contributions later as your income grows.

Select appropriate assets

Consider diversified options like ETFs that give you exposure to multiple companies or sectors. Whether you're interested in global technology companies, emerging markets or commodity sectors, choose investments that align with your long-term goals and risk tolerance.

Stay consistent

Pick a schedule that works for you – weekly, monthly or quarterly – and stick to it. Consistency matters more than timing the market perfectly. Set a reminder if it helps or mark it in your calendar. The key is building a habit that becomes second nature, so you keep investing even when markets feel uncertain.

Monitor your portfolio

Review your portfolio periodically to ensure your investments remain aligned with your goals but resist the urge to constantly adjust based on short-term performance. The power of dollar-cost averaging comes from staying the course.

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