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WalletPrep worksheet · Investing

What is dollar-cost averaging, and does it work?

Name ____________________ Date __________

Key ideas

  1. A fixed amount buys more shares when prices fall. $200 buys 4 shares at $50 and 8 shares at $25. Your average cost ends up below the average price.
  2. Paycheck investing is dollar-cost averaging. Your 401(k) contributions go in every payday at whatever the price is. There is nothing to decide each time.
  3. A lump sum invested at once often does better. FINRA notes that spreading money out tends to lower risk but often lowers returns over long periods.

Vocabulary

Dollar-cost averaging
Investing a fixed amount on a regular schedule, no matter the price, so you buy more shares when prices are low.
401(k)
A retirement savings plan offered through an employer. Money comes straight from your paycheck, often with an employer match.
Diversification
Spreading your money across many investments so that one bad company or sector does less damage to the whole.
Index fund
A mutual fund or ETF that tries to match a market index by holding the investments in it, rather than picking winners.
IRA
Individual retirement account: a tax-advantaged retirement account you open yourself at a bank or brokerage, separate from your job.
Target-date fund
One fund that holds a mix of stocks and bonds and slowly shifts toward bonds as the year in its name gets closer.

Work it out

Kim, 31, invests $200 on the first of each month in an index fund. Over four months the price goes $50, $40, $25, then back to $50. The prices are made up.

  1. Month 1 at $50
  2. Month 2 at $40
  3. Month 3 at $25
  4. Month 4 at $50
  5. Total invested
  6. Shares bought
  7. 21 shares at $50
  8. Total invested
  9. Gain on paper

Check yourself

  1. You invest $300 a month. The price is $30 in month 1 and $20 in month 2. How many shares do you own?

    • A. 20
    • B. 25
    • C. 15
    • D. 30

  2. Which of these is dollar-cost averaging?

    • A. Buying only after the market drops 10%
    • B. Investing a large bonus all on one day
    • C. Contributing the same amount to a 401(k) every paycheck

  3. What is the main downside of spreading a lump sum over many months?

    • A. Money waiting in cash may miss gains if prices rise
    • B. It is not allowed in an IRA
    • C. It always loses money
    • D. It raises your expense ratio

Your turn

Log in to your IRA or brokerage account and set up an automatic monthly investment into one broad index fund, dated for the day after payday. Even $25 a month starts the habit.

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Answer key

What is dollar-cost averaging, and does it work?

Work it out

  1. Month 1 at $50$200
  2. Month 2 at $40$200
  3. Month 3 at $25$200
  4. Month 4 at $50$200
  5. Total invested= $800
  6. Shares bought21
  7. 21 shares at $50$1,050
  8. Total invested− $800
  9. Gain on paper= $250
  1. Shares bought: $200 ÷ $50 = 4, $200 ÷ $40 = 5, $200 ÷ $25 = 8, then 4 again. 4 + 5 + 8 + 4 = 21 shares.
  2. Her average cost is $800 ÷ 21 = about $38.10 a share, below the average price of ($50 + $40 + $25 + $50) ÷ 4 = $41.25.
  3. 21 × $50 = $1,050. All $800 in month 1 would buy 16 shares, worth $800 now. Had prices only risen, the lump sum would have won.

Check yourself

  1. B. 25 $300 ÷ $30 = 10 shares and $300 ÷ $20 = 15 shares, so 10 + 15 = 25 shares.
  2. C. Contributing the same amount to a 401(k) every paycheck A fixed amount on a fixed schedule, regardless of price, is dollar-cost averaging. Waiting for a drop is market timing.
  3. A. Money waiting in cash may miss gains if prices rise Money you hold back sits in cash. If the market rises in the meantime, you buy at higher prices and end with less.