What's Dollar Cost Averaging and Why Is It Better Than Trying to Time the Market?

One of the most common investing mistakes is trying to time the market. It sounds great in theory -- instead of investing no matter what's going on, why not get in when you expect prices to go up? If you're right, you could make more money on your investments.

There are a few serious issues with this approach. For starters, it's practically impossible to accurately time the market. Even if you could, you wouldn't make that much more compared to simpler investing methods. And what often ends up happening is that you don't invest nearly as much money because you're constantly second guessing yourself.

Let's say the price of a stock that you like goes down. It seems like a good time to buy, since you can get it at a discount now. But then you start to wonder if it could drop even lower in a few hours, or tomorrow. When you're trying to time the market, this is what you go through all the time.

Fortunately, there's a much better and easier option. It's called dollar-cost averaging, and it takes all the guesswork out of investing.

How dollar-cost averaging works

Dollar-cost averaging is when you invest a fixed amount of money on a regular schedule. For example, you could invest $100 a week, or $500 on the first and 15th, or any other amount and schedule that you want.

The biggest benefits of dollar-cost averaging are how easy it is and how much time it saves. There's no debating whether to invest or how much. You just follow your schedule. With most top stock brokers, you can also set up automatic investments, meaning you don't need to spend any time making your investments.

The million-dollar question is what kind of results you can expect from dollar-cost averaging. And in a comparison of several investing styles, it did extremely well.

Dollar-cost averaging vs. other investing methods

In 2021, Charles Schwab ran the numbers on how multiple investing styles would have performed over 20 years of investing (from 2001 through 2020). For its hypothetical scenario, each of five investors received $2,000 to invest at the beginning of every year. Here were the investing styles:

• Perfect timing: Timed investments perfectly every year by always investing the full $2,000 when stock prices were lowest.
• Invest immediately: Put all $2,000 in the stock market on the first trading day of the year.
• Dollar-cost average: Divided the $2,000 into 12 equal portions and invested one portion at the beginning of each month.
• Bad timing: Timed investments poorly every year by always investing the full $2,000 when stock prices were highest.
• Stay in cash: Left the money in treasury bonds and never got around to investing.

Over those 20 years, each portfolio received $40,000. Here's how the results from these investing style compared:

A simple and effective way to invest

Charles Schwab's results weren't just a one-off. It analyzed time periods dating back to 1926, and the results were extremely similar for most 20-year time periods.

Perfect timing is the winner, but it's also impossible to achieve. Investing immediately and dollar-cost averaging both delivered consistently strong results as well, and even bad market timing turned a healthy profit. The worst performer was staying in cash, showing the danger of waiting to invest because you're forever waiting for the perfect time.

Dollar-cost averaging works so well because you can do it consistently. Investing immediately is also effective, but only when you have a lump sum. Dollar-cost averaging, on the other hand, is a strategy you can use on a regular basis.