What To Know About Dollar-Cost Averaging Investing Strategy

If you’re already contributing money to a 401(k) retirement account, you may not have realized it, but you’re practicing a popular investment strategy known as dollar-cost averaging.

Simply put, this approach means you’re investing fixed, equal amounts on a regular basis, say monthly or bi-weekly, rather than investing one lump sum of cash all at once.

With a defined 401(k) contribution plan, for example, you’re investing as you earn, regularly taking money from each paycheck throughout the year and putting it into the market. Dollar-cost averaging could also look like if you decide to invest $5,000 of your savings by splitting that cash into five parts, where $1,000 is invested each month for five months.

Dollar-cost averaging allows you to spread out your investments and buy into the market at different times at varying prices. In turn, these purchase prices ideally balance each other out, which is where the “averaging” part of the phrase comes from.

Experts often recommend this long-term investing approach (especially with broad market-tracking index funds) to people with low-risk appetites since contributing cash consistently over time reduces the impact of any market volatility on an investment. Not to mention, it allows investors to forget about the up and down movements of the market since their contributions aren’t influenced by what’s happening; they’re making contributions at regular intervals no matter what. This helps leave emotion-based investing off the table.

Like dollar-cost averaging, lump-sum investing can also help you build wealth — and even better, maximize your returns — albeit with the caveat that you’re taking on much more risk. After all, as we all know, no one can really time the market.

When investing a big wad of cash into the market all at once, your money gets put to work immediately. With dollar-cost averaging, however, only some of your money goes into the market to start and the rest is set aside for future contributions — this could allow you to catch future dips in the market, but your immediate gains may be smaller if the market takes off sooner than expected.

When investing with any method or strategy, the first step is to identify the potential returns as well as your risk tolerance.

Though you may get better returns over time with lump-sum investing, it’s not a good idea for those looking to lower their short-term downside risk since the potential for loss is greater.

Risk-averse investors, or those worried about market volatility, are better off using the dollar-cost averaging investment approach. A good place to start is with an S&P 500 index fund which has shown an average annualized return of approximately 10% since 1957.

For example, Charles Schwab’s S&P 500 Index Fund is a straightforward option with no investment minimum. Its expense ratio is 0.02%, meaning every $10,000 invested costs $2 annually — index funds generally have a 0.2% expense ratio, so this is notably low.

For an option with no expense ratio, consider the Fidelity ZERO^® Large Cap Index Fund. Though the fund doesn’t technically track the S&P 500, the Fidelity U.S. Large Cap Index tracks large capitalization stocks, which the website says, “are considered to be stocks of the largest 500 U.S. companies.”

You can also consider investing a fixed monthly amount through a robo-advisor like Betterment, which will create a custom portfolio of ETFs (which are similar to index funds) for you based on your risk tolerance and investing horizon.