How Dollar-Cost Averaging Can Benefit Your Portfolio During Volatility

Market volatility is unsettling and can tempt us to act, even if it’s not in our best interest. Some investors consider timing the market—selling their investments and keeping their portfolios in cash, waiting to reenter when they feel prices have bottomed.

Yet research continues to show that staying consistently invested in the market has the potential to outperform market timing over the long term.

What Is Dollar-Cost Averaging?

Dollar-cost averaging is a strategy that can help keep you invested during tough market conditions. This automatic investment approach helps keep your emotions in check, while also smoothing the effects of volatility on your portfolio.

Here’s how it works: You make smaller blocks of purchases in a target investment instead of buying a position all at once, and you build up to your desired investment at regular intervals. You can then calculate the average cost of your investment over several purchases.

Many investors already benefit from dollar-cost averaging in their 401(k) plans. Contributions are made with each paycheck cycle, and those funds purchase additional shares of their retirement investments over time.

Dollar-Cost Averaging During a Bear Market

It can be tempting to stop investing when times are tough and the markets are sinking. Dollar-cost averaging keeps you investing—and working toward your goals—regardless of what the market is doing. And in a bear market, you may have the opportunity to buy investments at a lower price.

Let’s run through a hypothetical example of investing in a bear market.

Suppose an investor has $600 in January and wants to invest it in a mutual fund. They can either invest the full $600 in January when the share price is $25, or they can invest $100 a month over six months at various share prices.

At the end of the six months, how did the investment fair under each purchasing method?

Under the lump sum method, the investor purchased 24 shares in January, so the investment value in June was $513 (24 shares times $21.38 per share). The investment decreased 14.5%.

With dollar-cost averaging—as the mutual fund declined below its January share price—each month’s $100 investment bought more than four shares on average. After six months, the investor accumulated 26.2 shares, and the investment was worth $560.16 (26.2 shares times June’s $21.38 share price). The investment is down only 6.64%.

Does Market Timing Work?

Instead of consistent buying, some investors get drawn into timing the bottom or dips in the market.

Academic research in finance has proved that trying to time the market accurately is nearly impossible. Berkshire Hathaway Chairman and CEO Warren Buffett gave his take on market timing at a past shareholder meeting.

Attempting to predict a market decline, let alone when it will end, is very difficult. I like to remind clients of the potential growth they miss out on by waiting for the “drop.” If the market goes up by 15% before it drops by 10%, they still would have been better off investing their money from the start.

Dollar-Cost Averaging Versus Buying the Dip

The strategy of “buying the dip” attempts to pinpoint market downturns. Here, an investor builds up money to invest but keeps it in cash and invests it only when the price of an investment declines (dips) from a recent high.

If an investor could accurately predict dips, would it not be better to just buy the dip?

A recent analysis looked at returns for a person with a 40-year time horizon who could time market bottoms perfectly. If they started investing in the S&P 500^® anytime between 1920–1980, dollar-cost averaging would still outperform buying the dip 70% of the time.² When the investor’s accuracy was reduced, and they invested within two months of the actual bottom, the strategy underperformed 97% of the time.³

It’s worth noting that neither method will save you from losses if the investment declines in value over your investment time horizon. But when looking at strategies for investing, you typically will do so in investments that you think will rise over time.

Why did consistent investing outperform?

The Power of Compounding

While waiting for the dip, the investor is building cash on the sidelines that does not benefit from investment returns that can compound over time.

Historically, the market can go several months and even years without experiencing a decline large enough to be considered a dip. Missing just a handful of days in the market can drastically reduce an investor’s average returns over the long term.

During times of volatility, there are often swings in the market in both directions—something investors don’t always think about. It’s not uncommon to see a big “up day” during a bear market, and if you miss out on those days too, you could hurt yourself in the long run. Staying in the market and putting your investments to work systematically positions you to capture the power of compounding, often called the “8^th wonder of the world.”

Of course, while compounding can lead to exponential growth with positive returns, negative returns can also erode capital.

Automatic Investing Tames Emotions and Simplifies Decisions

Dollar-cost averaging lends itself practically to the investment process. By taking the investment decision off the investor’s plate—much like what’s done with contributing to a 401(k) or other workplace retirement account—an investor can easily stick to an investment plan.

Breaking down contributions into several smaller blocks also greatly reduces the risk of regret from ill-timed purchases. When the market falls, you can be happy to add to your investments at lower prices, and when the market rises, you can be happy that you got in at lower prices.