What Is Dollar Cost Averaging – and Should You Be Doing It?

Sometimes I get a question from multiple clients in a short period, suggesting to me that it’s on people’s minds.

Lately, I feel like I’ve been answering a lot of questions about something called “dollar-cost averaging” — from clients and even from Barron’s.

It’s not an easy question to answer, though — because it’s one of those cases where the financial answer and the emotional answer don’t line up neatly.

What Is Dollar-Cost Averaging?

The first thing to understand is what dollar-cost averaging actually is. At the most basic level, it’s a systematic approach to moving from cash to an invested account, making regular investments over a given period of time.

The easiest example to understand is 401(k) contributions, which move money from your paycheck into your 401(k) on a steady basis, bit by bit, during every pay period. By investing money consistently over time, you’re putting cash to work both when the market is up and when it’s down.

If you’re investing $1,000 and the market is down, your $1,000 buys more shares of the underlying investments. If you’re investing the same amount and the market is up, your $1,000 buys a bit fewer. By having a disciplined process, you’re effectively smoothing out the market bumps along the way.

Does Dollar-Cost Averaging Work?

It’s not as simple a question as it sounds.

Think of it this way: If you KNEW the market was going to go up over a given period of time, the best thing to do would be to invest at the beginning of the period.

And if you knew the market was going to go down, the best thing would be to hold off and invest at the end.

The argument for dollar-cost averaging is that we don’t actually know the future — we don’t know for any given period whether equities (stocks and stock funds) will go up or down.

Here’s the rub, though: While we don’t know what will happen in the future, we do know pretty well what’s happened in the past. And historically, markets have gone up over time.

What Vanguard Analysis Found

Vanguard, the fund company, has done a lot of research around investing topics. Their researchers published a paper in 2023 that found lump-sum investing — i.e., investing the cash at the beginning of any given period — had historically outperformed dollar-cost averaging throughout the same period.

It makes sense when you think about it. If markets go up more often than they go down — which they have, historically — then you’d also expect lump-sum investing to pay off more often than dollar-cost averaging.

But that isn’t the whole answer.

Dollars vs. Feelings

Here’s why: Even though dollar-cost averaging tends to underperform a bit worse than lump-sum investing, it can be a smart behavioral finance strategy — particularly in times of uncertainty.

Here’s what Barron’s reporter Mallika Mitra wrote after our conversation.

There are two problems, says Rachel Elson, a financial advisor at Perigon Wealth Management in San Francisco, who tends to work with younger clients. The first is that we never know what the markets will do in any particular year. The second is that people tend to have an emotional attachment to money, and seeing a new investment evaporate in a market rout is painful.

 

“If you put a bunch of money into an investment account and then the market drops 10% the next week, how likely are you going to be to want to invest in the future?” Elson says. “You’ve just confirmed all of your fears.”

As I told Mitra: Dollar-cost averaging is most useful when it keeps you from psyching yourself out. And that can be especially true for people who are new to investing.

When Is Dollar-Cost Averaging the Best Move?

We sometimes recommend different strategies in different contexts.

• If you’re coming from a big cash position and you’re new to (or nervous about) investing, we might recommend dollar-cost averaging in over a few months.
• If you’re diversifying from an existing position — say, a concentrated chunk of employer stock — then we wouldn’t suggest it. You’re effectively going from one investment to another, and we don’t like to see people spend a lot of time sitting on cash and out of the market, unless that money is designated for a specific purpose.
• If you’re funding a 401(k), go ahead and take advantage of that systemized investing via your company’s payroll system. While you’re at it, aim to spread out those investments through the year. (If you used a bonus payout in early 2022 to max out your 401(k), you might recall how you felt about that balance by year-end.)
• If you’re funding a Roth, we usually try to get that done with the first chunk of free cash in any given year — because the amount is relatively small, and the longer time frame lets you ride out ups and downs in the short term.

All of which is to say, questions about dollar-cost averaging often draw the most financial-planning answer ever: It depends.

As always, reach out to your advisor if you have any questions about whether, and when, dollar-cost averaging is the right answer for your own investment goals.