Dollar-cost averaging takes a lot of the effort and worry out of investing. Image source: Getty Images.
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Bonus time for some is around the corner, and you might be coming into a nice chunk of change. Should you invest all that cash right away, or should you spread out your windfall and invest it over a period of time?
If you've chosen the latter route, you might be opting for an investment strategy called dollar-cost averaging.
With dollar-cost averaging, you invest your money in equal portions, at regular intervals, regardless of the ups and downs in the market.
Let's say you received a bonus or other type of payout of $10,000. Instead of investing that amount all at once, with dollar-cost averaging you might split that $10,000 into 10 parts and invest $1,000 a month for 10 months.
You might already be engaging in dollar-cost averaging without even realizing it. If you have a 401(k) or another type of defined contribution plan, then your contributions are allocated to one or more investment options on a regular, fixed schedule, regardless of what the market is doing. Every time this happens you are dollar-cost averaging.
Before you start divvying up that bonus check, here are three things to know about dollar-cost averaging.
Why might someone consider dollar-cost averaging?
It would be great if we could buy stocks, or other types of investments, when the market is low and sell when the market is high. Unfortunately, efforts to "time the market" often backfire, and investors end up buying and selling at the wrong time.
When stocks go down, people often get fearful and sell. Then, when the market goes back up, they might miss out on potential gains. On the flip side, when the stock market goes up, investors might be tempted to rush in. But they could end up buying just as stocks are about to drop.
Dollar-cost averaging can help take the emotion out of investing. It compels you to continue investing the same (or roughly the same) amount regardless of the market's fluctuations, potentially helping you avoid the temptation to time the market.
When you dollar-cost average, you buy more shares of an investment when the share price is low and fewer shares when the share price is high. This can result in paying a lower average price per share over time.
And by wading in, as opposed to handing over your money all at once, dollar-cost averaging can help you limit your losses in the event the market declines.
What are the potential downsides of dollar-cost averaging?
Dollar-cost averaging can be a helpful tool in lowering risk. But investors who engage in this investing strategy may forfeit potentially higher returns.
If the market goes up during a period when you are dollar-cost averaging, you might miss out on the potential gains you could have had, had you invested right away in one fell swoop.
"If you dollar-cost average, you have your money in cash over a greater period of time," said Mike Piper, author of the blog ObliviousInvestor.com. Money held in cash generally produces lower returns but has less risk.
A 2012 study by Vanguard found that historically investing your money in a lump sum vs. dollar-cost averaging produced better results 66% of the time. The longer the time frame, the greater the chance that investing all at once beat dollar-cost averaging, the study found.
"We conclude that if an investor expects such trends to continue, is satisfied with his or her target asset allocation, and is comfortable with the risk/return characteristics of each strategy, the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible," the Vanguard study authors wrote.
Of course, this doesn't apply to something like your 401(k), because in that situation, you are investing the money as you earn it -- not holding money in cash until a later date.
Also keep in mind, if you engage in dollar-cost averaging, you might encounter more brokerage fees. These fees could erode your returns. And of course you need to be disciplined with that money that's sitting on the sidelines to actually invest it, and not erode it with purchases.
What's the bottom line for investors?
As is the case in all aspects of investing, it's important to consider potential returns as well as your tolerance for risk.
Investing all of your money right away might yield higher returns than dribbling out smaller amounts over time.
But if you're looking to reduce your risk and control your emotions, or you fear that the market is heading for drop, then dollar-cost averaging could be a viable strategy -- even if that means forfeiting some potential upside. You might consider how you would feel if you invested all of your bonus at one time and the market swooned soon after.
"Risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline," the authors of the Vanguard study wrote. "If the investor is primarily concerned with reducing short-term downside risk and the potential for regret, then dollar-cost averaging may be a better alternative."
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