Dollar-Cost Averaging

What is dollar-cost averaging in a 401(k)?

Dollar-cost averaging means investing equal dollar amounts at regular intervals, regardless of market changes. A consistent dollar contribution from each paycheck can follow this approach. If you contribute a percentage of pay, the dollar amount may change as your earnings change. 

 How Regular Investing Works and What It Cannot Guarantee 

Dollar-cost averaging means investing a set dollar amount on a regular schedule, regardless of whether prices have risen or fallen. If you contribute to your 401(k) from each paycheck, you may already use this approach. The amount buys more shares at a lower price and fewer shares at a higher price. That creates a repeatable investing process without requiring you to choose one perfect day to invest.

For many people, the schedule is already built in: payday. If you invest a consistent dollar amount from each paycheck at regular intervals, you may already be practicing dollar-cost averaging. When your contribution is a percentage of pay, the dollar amount can change with your earnings; it remains regular investing, though it may not match a fixed-dollar example exactly.

The approach can help people who keep waiting for better market conditions before getting started. It also has limits that matter for retirement planning. A regular schedule does not guarantee a profit, protect you from every loss or make a poorly chosen investment suitable. You still need to understand what you own and how it fits your goals.

There is also a difference between investing money as you earn it and spreading out money you already have available. One is a payroll habit; the other involves deciding how long to keep part of a lump sum out of the market. A simple share-purchase example helps explain the mechanics so you can ask the right questions about your own savings process.

How dollar-cost averaging changes share purchases

Suppose you invest $100 each month in the same hypothetical investment. In the first month, a $10 share price lets you buy 10 shares. In the second month, a $5 price lets you buy 20 shares. In the third month, a $20 price lets you buy five shares, assuming fractional-share rules and transaction costs do not affect these purchases.

To find your average purchase cost, divide the total invested by the total shares purchased. That calculation weights the result by what you actually bought, rather than treating each quoted price as an equally sized purchase. It differs from the simple average of the three quoted prices, which is approximately $11.67. The SEC’s definition of dollar-cost averaging explains why fixed contributions buy different quantities as prices change.

In the hypothetical three-month example, $300 buys 35 shares at an average cost of approximately $8.57 per share. The investment can still lose value after those purchases.

This example was selected to show the arithmetic, not prove that regular investing beats another strategy. If the share price later falls to $4, the 35 shares would be worth $140. That is less than the $300 contributed, before considering costs or taxes. A lower average purchase cost does not create a floor under the account’s value.

Use a schedule without ignoring the investment

Market news can give a hesitant saver a new reason to wait. A schedule offers a way to make the contribution decision in advance, while still leaving room to review whether the amount is affordable.

A regular schedule can reduce the number of times you ask whether today is the right day to contribute. That can be helpful when headlines keep giving you another reason to wait. It does not remove the need to review the fund, your time horizon and your ability to keep contributing. The investment itself still determines the risks you take.

Buying a single company’s stock regularly leaves you exposed to that company’s fortunes. Buying a diversified fund can spread exposure more broadly, depending on its holdings. Neither approach makes market losses impossible. Review what the fund owns before assuming the contribution schedule supplies diversification on its own.

Separate payroll contributions from a lump-sum decision

When you invest through payroll, you generally put money to work as it becomes available. You are not choosing to hold back money you already had for months. FINRA distinguishes this situation from gradually investing an existing sum in its discussion of the benefits and limitations of dollar-cost averaging. The distinction changes the trade-off.

If a bonus or inheritance is already available for long-term investing, phasing it in leaves part in cash until later dates. That can reduce exposure to an immediate decline, but it can also mean missing gains while that portion remains uninvested. Compare the schedule, transaction costs and your ability to follow through. A financial professional can help you evaluate the choice without treating either approach as automatically best.

What happens when prices keep rising or falling?

The outcome depends on the path of prices and what happens after the purchases. If prices rise throughout your purchase period, money invested later generally buys at higher prices than money invested earlier. If prices fall, later purchases buy more shares, but the shares already owned lose value. A lower average cost than the average quoted price does not mean the account will be worth more than you contributed.

The same three-month example can help you see the distinction. At $20 per share immediately after the third purchase, the 35 shares would be worth $700 before costs and taxes. At $4 per share later, they would be worth $140. Those hypothetical outcomes show how the ending price affects value; neither suggests that either price is likely or that a real investment would move in this pattern.

Consider the costs of a regular schedule

Check whether your account or investment charges transaction fees, sales charges or other costs. If a fee applies to each purchase, a schedule involving more purchases can create more transaction costs. Some retirement-plan investments have no separate charge for each payroll purchase, but they may still have ongoing fund or plan expenses. Your plan’s disclosures explain the costs that apply.

Also check when payroll deductions are actually invested. A contribution rate expressed as a percentage of pay may produce different dollar amounts when your pay changes. That remains a regular investing habit, but it will not match the equal-dollar illustration in every pay period. Knowing the difference helps you interpret your own statements without assuming that the example describes your account exactly.

Make a schedule you can maintain

Check how often your retirement contributions are invested and which investments receive them. Review whether the amount fits alongside necessary bills, debt payments and emergency savings. If the contribution is a percentage of pay, the dollar amount may change when your earnings change. That is different from the fixed $100 used in the illustration, though the regular investing habit remains.

Decide when to review the contribution rather than reacting to every price move. A planned review gives you a point to examine affordability and investment fit together. If you pause contributions because your circumstances require it, identify what would allow you to restart. Avoid assuming an automated deduction is a substitute for periodically checking the account.

Start with your next scheduled contribution

Confirm the contribution amount, destination and next investment date in your plan’s system. If you are reviewing a lump sum instead, write down how much is available now and when you expect to need it. Those facts make the discussion with a financial professional more specific. McClone’s Learning Center offers related education as you build a savings approach you understand and can maintain.

Securities offered through LPL Financial, a Registered Broker Dealer, Member FINRA/SIPC. Investment advice offered through Gateway Wealth Partners, LLC, a registered investment advisor. Gateway Wealth Partners, LLC, McClone Retirement Advisors and LPL Financial are separate entities. TAX AND LEGAL DISCLAIMER: McClone and its affiliates do not provide tax, legal or accounting advice. Any material prepared is for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and/or accounting advisors before engaging in any transactions.