Dollar-Cost Averaging into Index Funds
Buy a fixed amount every month: you automatically buy more when prices are low and less when they're high. Compare dollar-cost averaging with a lump sum in different markets.
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Text version · Indexes & ETFs, lesson 8: “Dollar-Cost Averaging into Index Funds”
Buy a fixed amount every month: you automatically buy more when prices are low and less when they're high. Compare dollar-cost averaging with a lump sum in different markets.
Invest the same amount every month
dollar-cost averaging means investing a fixed amount at fixed intervals. $300 a month buys 30 units at $10 and automatically 60 units when the price drops to $5: more when it's cheap, less when it's expensive, with no need to time the market.
Average cost below average price
Over those three months you invested $900 and got 120 units, an average cost of $7.50, lower than the $8.33 average of the three prices. That's because you bought more in the cheap month, giving it more weight.
In a steady rise, a lump sum does better
If the price rises steadily, buying later costs more, and a lump sum that buys everything at the lowest point usually earns more. DCA's strength is that you don't have to time the market and your buys are spread out.
DCA doesn't protect your capital
When prices keep falling, your average cost falls too, but usually stays above the current price, so DCA still loses money. It's a discipline, not a way to protect your capital.
Key takeaways
- Dollar-cost averaging = investing a fixed amount at fixed intervals. The lower the price, the more shares you get.
- Your average cost = total invested ÷ total shares, and it's never higher than the simple average of the prices over that period.
- Dollar-cost averaging does best when prices fall and then recover; in a steady rally, a lump sum usually makes more.
- It doesn't eliminate losses: if prices keep falling, you're still losing money.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- The default "Dip, then bounce": the price ends back at $100. What's the lump sum's return? And DCA's?
- Click the reset button on the left of the timeline to go back to month 0, then press ▶: what happens to the green bars (units bought) in the months when the price is lowest?
- Switch to "Up": who wins this time? Why?
- Switch to "Down": what's the DCA average cost? Is the return positive or negative?
Quiz and explanations
- 1. You invest $300 a month, and the prices over three months are $10, $5 and $10. What's your average cost?
- Answer: $7.50.Shares: 30 + 60 + 30 = 120. Total invested $900, so average cost = $900 ÷ 120 = $7.50, below the simple average of the three prices, $8.33.
- 2. If the price rises steadily from the first month, how does dollar-cost averaging compare with a lump sum (buying everything in month one)?
- Answer: The lump sum usually makes more.In a steady rally, the later you buy the more you pay. A lump sum buys everything in the cheapest first month, so it usually does better.
- 3. You invest $100 a month at prices of $20, $25 and $20. After the third purchase, what's your position worth?
- Answer: $280.Shares: 5 + 4 + 5 = 14, worth $280 at the latest price of $20. You've put in $300, so you're currently down $20 on paper.
Terms in this lesson
- average cost (Average Cost): Your average purchase price per share after several buys; it's also your breakeven price.
- dollar-cost averaging (Dollar-Cost Averaging): Investing a fixed amount at regular intervals, so you automatically buy more when prices are low and less when they're high.
- lump sum (Lump Sum): Investing all your money at once, so everything that follows depends on that one purchase price.