Dollar-cost averaging is a way to invest in stocks and other assets that you may not know about. Still, there's a good chance that you're practicing it anyway. And that's good, because dollar-cost averaging can be an effective way to build wealth.
What dollar-cost averaging is
When you dollar-cost average, you invest a fixed sum of money at regular intervals, no matter the price at which you're buying into your investment. This is unlike the usual ways we tend to go about investing -- for example, spending our intended investment money all at once or holding on to our money until we think we've spotted bargains.
With dollar-cost averaging, if you're investing, say, $1,000 per quarter into a stock, you'll buy 50 shares when it's at $20 per share and 40 shares when it's at $25. This means you get more shares when the price is low and fewer when it's high. Thus if the stock is overvalued at some point, you'll buy fewer shares at the inflated price than you will at the discount. You're not assessing the value you get for the price, though, or judging whether the stock is a good buy at each price. You're just sticking to a simple plan.
Why you might dollar-cost average
Some people will be surprised to learn that they have been dollar-cost averaging for years -- if, for example, they have been having a certain sum taken out of each paycheck and invested in a 401(k) account at work. In such a situation, they will have designated where the money is invested, such as in an S&P 500 index fund, and they'll accumulate more shares with each purchase when the price of the index is low and fewer shares when it's high.
So why would you want to dollar-cost average? Well, it's a good way to keep adding money into the stock market (or other investments) over time without having to conduct research and make a decision each time you plunk down money. It also reduces the risk of investing a big sum only to see that investment crash soon after.
Dollar-cost averaging is also handy when you only have small sums to invest and don't want to wait for them to accumulate into a large sum before investing. With dividend reinvestment plans, or DRIPs, for example, you can invest small amounts -- as little as $25 or so -- at a time into a number of great stocks. You can also use a good brokerage that charges very little per trade; a $400 investment can be worthwhile if the trading commission is only $8. Remember, if you're paying a $25 commission for a $400 investment, you're forking over a hefty 6% of its value just to trade. I recommend aiming for 2% or less.
The strategy can also make sense if you're on the fence about a particular investment. Perhaps you believe strongly in a company's future but find its stock only reasonably valued at best. You might dollar-cost average into the stock over time so that if it falls to a lower level, you'll still be snapping up shares and you won't have spent too much when it was priced higher. You might execute a brief and simplified version of the strategy, too, perhaps splitting your intended investment amount in thirds and buying it over three months.
Imperfect but useful
Dollar-cost averaging isn't a perfect strategy, though, because while you do limit your downside risk by not investing a large lump sum all at once, you can also limit your upside. After all, if that lump sum is invested at what turns out to be a great time, you can make more money.
Meanwhile, some studies, such as one by Vanguard, have found that lump-sum investing performs better than dollar-cost investing and that stretching an investment over time tends to decrease returns. That makes sense, because, over the long run, the stock market tends to rise, so if you're investing gradually, you're eventually paying higher prices for shares. Still, there remains a place for dollar-cost averaging -- for the risk-averse, for those with limited dollars, and for those indexing in 401(k) accounts. And in some markets, such as falling ones, dollar-cost averaging can shine.
However you invest, the most important thing is to simply do it. For many people, dollar-cost averaging is a helpful approach. For others, buying in lump sums when great opportunities present themselves is better still.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.