Dollar-cost averaging is a term that was made popular by David Chilton in his most famous book, The Wealthy Barber (which by the way, I recommend to anyone who asks me what they should read for their first personal finance book). It can be tricky to grasp at first, but the benefits are clear once you wrap your head around it. So what is dollar-cost averaging, and why should you do it?

Dollar-Cost Averaging, Explained

At its core, dollar-cost averaging is the end result of you saving consistent amounts of money over time. Investopedia defines dollar-cost averaging as “an approach to purchasing an investment in which the buyer spreads out their purchases so that the total price paid is less affected by market timing.”

If that sound a lot like just putting a little bit of money away each month into your investments… that’s because it is. When you invest monthly, you’re doing dollar-cost averaging by default. And that’s a great thing!

Here’s a chart that shows how it works. Let’s say you’re saving $1,000 a month, but the price of your investments fluctuates each month. What does that mean for you? It means that your $1,000 will buy a different number of shares at different price levels.

As you can see, when the price is $50, you can only afford 20 shares with your $1,000. At a unit price of $42 though, you can buy around 24 shares. Since you can’t predict the market, dollar-cost averaging is a way to make sure you’re always buying a little bit, no matter what the price is doing.

Benefits of Dollar-Cost Averaging

First of all, when you invest the same amount of money each month, it takes all of the guesswork out of trying to time the market. Sure, you’ll buy when things are high, but you’ll also buy when things are low, coming out to about average in the end.

Second, it takes the emotions out of investing, which makes you far less likely to fall victim to all of the pitfalls that many investors make (like buying high and selling low, for example).

Third, dollar-cost averaging during price fluctuations actually allows you to purchase more shares, on average, than if prices were to slowly and steadily increase over time. Let’s look at another view, where the unit price increase steadily, instead of jumping around all over the place:

In both of the above charts, the unit price starts at $50 in January and ends at $72 in December – but take a look at the final tally of units owned. When prices are volatile, you end up with 220 units. When they increase steadily, you only end up with 199. Without doing anything differently, you actually end up with more units as a result of price fluctuations! How’s that for a benefit? If you’re dollar-cost averaging your investments, price fluctuations become a reason to cheer, not freak out.

Who can use dollar-cost averaging?

Dollar-cost averaging is for everybody. Whether you’re new to investing or you’ve been doing it for years, it’s an important tool in your investing toolkit. Most people who think they can time the market are dead-wrong, and wind up with less gains than they would have had if they had just invested consistent amounts regularly.

What’s that saying about having just enough knowledge to be dangerous?

This method of investing is especially helpful if you’re new to investing though. It can be done automatically, takes all the stress and guesswork out of investing, and reduces the overall volatility of your portfolio – all good things.

By the way: if you’re lucky enough to work for a company that offers a pension plan that matches your contributions, then you’re likely already taking advantage of dollar-cost averaging by putting a bit of money away each and every month!

Wrapping it Up

Dollar-cost averaging is what allowed me to keep my cool while I was investing through my first economic downturn, which happened to be the 2008 global financial crisis. Rather than panic and sell, I kept investing through the downturn, with the net result being that I actually made a tidy sum of money through all of the turbulence. No matter whether you’re new to the game, or been playing for years, you can and should be taking advantage of dollar-cost averaging as you save for major milestones like retirement.