Dollar-cost averaging—the practice of purchasing securities at fixed intervals and in equal amounts over time rather than in one lump sum—has long been used as a way to avoid jumping into the market at the wrong time.
To illustrate how dollar-cost averaging, or DCA, works, consider an investor wishing to buy $10,000 worth of shares of a mutual fund. He could use the lump-sum approach and buy all the shares at once. However, there would be a risk that the market could turn negative shortly thereafter, resulting in an immediate loss on his new investment. Rather than try to determine when the time is right to buy, the investor could ease into the position—for instance, by purchasing $1,000 worth of shares every month for 10 months. That way, if the fund loses value during the time period, less of the investment is exposed to this loss and the investor ends up buying some of the new shares at a lower price than he would have with the lump-sum approach. Of course, if the fund’s shares continue to rise, dollar-cost averaging would impose an opportunity cost compared with the lump-sum approach, which, in hindsight, would have produced better results. But, of course, none of us invests in hindsight.
One of the primary benefits of DCA is that it may reduce volatility when buying securities. Rather than risk a purchase price that’s too high, DCA allows an investor to buy more shares when prices are low and fewer when they are high during a given time period. It also offers investors a system that avoids the challenge of market timing. Even though DCA may not always result in the highest long-term performance, it may be a good strategy for investors jittery about where the market is headed.
DCA is most often mentioned with regard to stock-related purchases, probably because equity markets tend to be far more volatile than bond markets. However, this approach can be used when buying bonds or bond funds, as well. In fact, given the tapering of the Fed’s bond-buying stimulus program and the uncertainty regarding interest rates, which some experts foresee rising some time this year, this might be a good time to use DCA when buying new bonds or bond funds, or if rebalancing a retirement portfolio, to add to existing fixed-income holdings.
One option would be to sell some stock holdings and keep the money in a cash account before dollar-cost averaging into bonds. By putting the money into cash first, equity exposure is reduced in case a market downturn should materialize, and exposure to interest-rate risk is limited by not putting assets all into bonds right away. Instead investors can ease into bonds slowly, so if rates do start to rise and bonds lose value, they can avoid some of those losses while buying more bonds than they would have if they had jumped in with a lump sum.
Given the unpredictable nature of the markets, it’s easy to see why DCA appeals to many investors. It can help reduce volatility and the odds of buyer’s remorse when investing a lump sum at what turns out to be exactly the wrong time.
Returns and principal invested in stocks are not guaranteed. Investing does not ensure a profitable outcome and always involves risk of loss. Dollar-cost averaging does not ensure a profit or protect against a loss in declining markets. Dollar-cost averaging involves continuous investment regardless of fluctuating prices. Investors should consider their financial ability to continue purchases through periods of high price levels. The investment return and principal value of mutual funds will fluctuate and shares, when sold, may be worth more or less than their original cost. Mutual funds are sold by prospectus, which can be obtained from your financial professional or the company and which contains complete information, including investment objectives, risks, charges and expenses. Investors should read the prospectus and consider this information carefully before investing or sending money.
©2015 Morningstar, Inc.