How Dollar-Cost Averaging Works in Turbulent Markets

Benjamin Graham, known as the father of value investing, said, "The investor's chief problem -- and his worst enemy -- is likely to be himself. In the end, how your investments behave is much less important than how you behave." Graham's words point to the importance of keeping a level head no matter what's happening in the market. And dollar-cost averaging (DCA) may be the strategy to help you do just that.

Dollar-cost averaging basics

DCA is the practice of investing a set amount at regular intervals, rather than investing a larger amount at one time. Proponents of DCA say the approach minimizes the chances you'll mistime your buy, when share prices are at their peak. The strategy often results in a lower cost-basis, which translates to higher gains.

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There's another side to this argument, though. If you trade in an account that charges you for every transaction, DCA does increase your costs. And if share prices are trending up, investing monthly over time would result in a higher cost basis and lower gains vs. investing a larger sum upfront.

Of course, if you don't have a large amount of cash to invest right now, that DCA downside is largely irrelevant. In that case, your options are to start investing small amounts regularly or to start saving and then invest a single, large sum later. Between those two choices, DCA is the better approach in a rising market. You'd benefit from earlier purchases at lower share prices, plus more time in the market for your investments to grow.

DCA in 2020

How does DCA perform in turbulent markets, like what we've seen in 2020? Take a look at the table below. It shows how a $500 monthly purchase of iShares Core S&P 500 ETF (IVV -1.24%) would've played out so far this year. For the sake of our example, let's assume you purchased these in a Fidelity account that supports dollar-based, fractional buys.

Table data source: Morningstar and author calculations

You can see how the share price fluctuated, and how that affects the number of shares you could buy with your $500 monthly investment. After six months, you would have spent $3,000 purchasing a total of 10.242 shares of IVV.

DCA vs. single investment

Alternatively, you could have invested the $3,000 all at once. Looking at the same dates, you can see that a single investment on January 15 would've resulted in the highest cost per share, while a single investment on March 15 would have given you the lowest cost per share. The table below shows how the DCA approach compares to a single investment on different dates throughout the year, ordered from lowest average cost per share to highest.

Table data source: Morningstar and author calculations

As you can see, DCA smooths over the volatility. You would have made some buys when the share price was higher and some when the share price was lower. The net result is, however, is moderate -- an average cost per share that's right in between the peak and the trough.

In hindsight, you would have gotten the most for your $3,000 by making a single buy in the middle of March. But let's be honest. Were you thinking about investing thousands when the market was showing clear signs of trouble? Most investors were doing the opposite, trying to get out ahead of a big free fall. It's more likely you would have chosen to invest your $3,000 in January, when the stock market was strong and coronavirus was China's problem.

DCA neutralizes emotion

DCA's biggest advantage is the structure it imposes. Follow your DCA plan and you neutralize the emotions, hunches, and gut feels that can push you toward unwise investing decisions. It is true that you won't get the best possible results with a consistent monthly buy, but you won't get the worst possible results, either.