Key Takeaways
- Dollar-cost averaging reduces the impact of market volatility by ensuring an investor contributes a stable amount at regular intervals.
- Mutual funds make DCA easy through automatic investment and reinvestment features.
- The combination promotes discipline and reduces emotional decision-making.
- DCA and mutual funds are an ideal combination for those with a long-term investment plan that will likely experience market volatility.
As famed fund manager Peter Lynch once quipped, “The only problem with market timing is getting the timing right.” Even the most seasoned investors struggle to consistently buy low and sell high, the result of both unexpected volatility in the market and the psychology of investing. Fortunately, dollar-cost averaging (DCA) offers a straightforward solution: investing a fixed amount at regular intervals, regardless of the conditions of the market.
DCA is a behavioral remedy designed to reduce the likelihood that an investor’s emotions will lead him to an ill-advised decision. When applied to an appropriate investment vehicle—such as mutual funds, given their automatic investment features and natural diversification—it can be a powerful tool to encourage discipline and help to smooth out volatility in the market. A strategy employing both DCA and mutual funds may be particularly useful for long-term and retirement-focused investors.
What Is Dollar-Cost Averaging—and Why It Works
While opinions about market timing vary widely, for most investors, it is clear that trying to time your buys and sells to optimize the price of securities is not an effective strategy. In effect, DCA takes the element of choice out of the process for an investor.
An investment approach based on DCA typically involves investing a predetermined and fixed amount of money in one or more vehicles on a periodic basis. This means an investor no longer has to attempt to navigate the emotional back-and-forth of choosing how much to invest at any given time, or when to execute a trade.
As the price of a security fluctuates over time, DCA naturally helps investors to buy more shares when prices fall and fewer when prices rise. In this way, DCA is particularly useful during periods of more intense market volatility. In fact, a recent empirical study by Sang et al. demonstrated that DCA provides risk-adjusted advantages in volatile scenarios. In effect, DCA helps to smooth over turbulence in security prices, although the effectiveness of the strategy does depend upon the frequency of investments, transaction costs, and other variables.
Even for extended periods in which the S&P 500 is up, there may be volatility that is not immediately apparent. As an example, the S&P 500 climbed by about 14% in the first 10 months of 2023, which might lead investors to assume that it would be possible to time investments to maximize gains over that period. In actuality, though, fewer than 10 trading days accounted for most of those gains.
Why Mutual Funds Are Ideal for Dollar-Cost Averaging
Mutual funds are an excellent vehicle for investors pursuing a DCA approach, thanks in part to the ease with which one can set up recurring investments. These funds are typically set up to facilitate automated monthly contributions, with many also providing reinvestment options to help put distributions back to work as well.
Mutual funds also offer built-in diversification and are managed by a team of professionals to make it even easier for retail investors to avoid the risk of trying to time the market. Most mutual funds allow the purchase of fractional shares (while not all exchange-traded funds, or ETFs, can say the same), which makes the administrative burden of overseeing an investment structured according to DCA principles easier with these funds.
Rounding out the list of potential benefits of mutual funds for those considering this investment approach are their relatively low cost—particularly for so-called no-load funds that do not carry a commission or sales charge—and their frequent inclusion in retirement accounts, which may make it possible for investors to increase their regular contribution thanks to employer matches.
Real-World Benefits for Long-Term Investors
It is true that DCA may not maximize returns for investors during consistent bull market scenarios. However, many long-term investors—such as those saving for retirement—stand to benefit from staying the course with this approach.
Besides the benefits of investment discipline, reduction of emotional risk, and diversification, one of the biggest perks of DCA and mutual funds for retirement savers is the automatic nature of contributions. Given that many savers fail to make regular contributions to their retirement accounts, this benefit is significant.
Over a career of saving toward retirement, there are bound to be highly volatile periods—the market turbulence of 2008, 2020, and 2022 are some of the most recent examples. DCA helps investors maintain a consistent approach, reducing any tendencies to try to time the market (and, in turn, the trap of inadvertently buying high and selling low).
Dollar-Cost Averaging With Mutual Funds vs. Other Investment Vehicles
Besides mutual funds, it is possible to use DCA with other investment vehicles:
- ETFs: These provide similar diversification, but as mentioned above, they may not be available as fractional shares, which can make contributing a consistent dollar amount inconvenient, depending on the price of the ETF shares.
- Individual stock investments: The benefit of smoothing over price volatility is also applicable in stock investments. However, individual stocks do not offer diversification, ease of automation, reduced transaction costs, or the other perks of mutual funds. Many retirement accounts do not allow investments in individual stocks, either, making this option less beneficial for retirement savers.
Tip
DCA may be particularly helpful for hands-off investors looking to automate as much of the investment process as possible while still maintaining proper allocation and minimizing expenses.
The Bottom Line
Investors adopting a dollar-cost averaging approach schedule their purchases on a regular basis, investing the same amount of money each time in their target security or securities. Some of the benefits of this approach include reducing the likelihood that an investor’s emotions will enter the decision-making process, smoothing over market turbulence, and simplicity.
While DCA can work with many investment vehicles, mutual funds are a natural pairing thanks to their automated contribution schedules, low cost, built-in professional management, diversification, and close ties to retirement accounts.