Understanding simple investing strategies, such as dollar cost averaging (DCA), can help build confidence for any investor, from the novice to the experienced.
Dollar cost averaging can be implemented in most types of accounts, whether you’re a do-it-yourself investor with an Ally Invest Self-Directed Trading account or more into automated investing with a Robo Portfolio.
Read more: Which investment accounts are right for you?
What is dollar cost averaging and how does it work?
With this approach, you invest a set dollar amount at regular intervals (like on a monthly basis, as part of your budget) in a certain security (or securities). The goal is to make investing a habit, take the emotion out of it and help you avoid the temptation of trying to time the market.
When you invest a consistent amount regularly and over a long period of time, you make a purchase whether the price is high or low. The idea being, as the market fluctuates over time, your average purchase price will hopefully even out.
Example of dollar cost averaging in action
Get a sense of DCA using the hypothetical situation below.
Investment cadence | Investment amount | Share price | Shares purchased |
|---|---|---|---|
Month 1 | $500 | $20 | 25 |
Month 2 | $496 | $16 | 31 |
Month 3 | $483 | $23 | 21 |
In this example, the total invested is $1,479, the average cost per share is $19.21 and the total shares purchased is 77. Expand this example over a longer period of time, and you can see how, in theory, that might even out the price, although, as with any investing, you can’t know for sure what a security is going to do, so there’s no guarantee the price will level out.
Benefits of dollar cost averaging
DCA has many advantages for investors, as it can:
Help reduce emotional investing decisions to prevent costly, irrational behavior driven by market hype or panic
Encourage a long-term perspective by establishing a disciplined investment process
Potentially minimize short-term impact of market fluctuations
Make investing more accessible through regular, small contributions
The downside to dollar cost averaging is that you don’t know that your prices will eventually even out over time. In addition, some investors believe your overall potential return could be lower than if you were to invest a larger amount up front. In the end, it’s up to your goals, timeline and the risks you’re comfortable taking.
Is dollar cost averaging right for you?
That depends on a few factors:
Your investment timeline and goals: Dollar cost averaging is typically considered a strategy for investors who have a longer timeline on their investing goals.
Your risk tolerance and market outlook: Risk-averse investors might prefer DCA since its goal is to smooth out the impact of market volatility.
The potential for brokerage fees with frequent transactions: Many modern brokers, such as Ally Invest, have moved to commission-free trading for stocks and exchange-traded funds (ETFs), but some might still charge a per-transaction fee — so check with yours.
Learn more: Ally Invest offers accounts to match wherever you are in your investing journey
Dollar cost averaging vs. lump sum investing
The goal of dollar cost averaging can be understood more clearly when compared to the lump-sum investment strategy. The latter approach may be better suited for the more risk-tolerant investor because they invest as much as they can all at once. Here is an example:
Investment cadence | Investment amount | Share price | Shares purchased |
|---|---|---|---|
Month 1 | $1,500 | $20 | 75 |
Month 2 | $0 | $16 | 0 |
Month 3 | $0 | $23 | 0 |
In this example, the total invested is $1,500, but the average cost per share is $20 and the total shares purchased is 75. However, with more time in the market, there would likely be more fluctuations and the difference could be greater in one direction or the other.
Ultimately, the choice depends on your investing style. You may invest the same amount with both lump-sum investing and dollar cost averaging, but your purchases will be spread out over time with DCA, which often makes it the more palatable strategy to the risk-averse investor.
How do I get started with dollar cost averaging?
If you're considering this investment strategy, here are a few steps to get started.
1. Setting investment goals and understanding your risk tolerance
Take the time to define what your ultimate financial goals are. Whether it’s your retirement or a down payment on your future home, knowing your goals can help keep you focused on your timeline and the bigger picture.
Additionally, understand your risk tolerance before you start investing — that way you know whether to gravitate more toward high- or low-risk investments.
2. Choosing your investment assets
Next, decide where you'll invest your money. You might consider a mix of mutual funds, index funds, ETFs and more (like real estate) for a more balanced portfolio.
An Ally Invest Robo Portfolio can help you build a diversified portfolio without the DIY aspects — and you can even automate transfers into your account.
3. Determining investment frequency
Now think about how often you want to invest. Is it every other week or once a month? There's no right or wrong answer, so base your timing on what makes sense for your finances. Once you set your cadence, the key to dollar cost averaging is to stick with it.
With Ally Invest Self-Directed Trading, you have control over exactly where you’re investing your funds — great for the DIY investor.
4. Monitoring
Dollar cost averaging removes a lot of the emotion that can come from a more actively managed portfolio. But this investment strategy doesn't mean you should set it and forget it. Keep an eye on your progress, as you may want to make some adjustments over time.
If you're able, consider increasing the amount of your regular contributions. Or, if your investments are underperforming over a longer period, it might be time to reevaluate your portfolio. You won't want to make significant changes frequently, but you should review your portfolio regularly.
Pursuing your best financial future
Dollar cost averaging can't ease all your investment-related anxieties, but this patient, consistent approach may help you invest with a little less nail-biting.
