What is Dollar Cost Averaging?

by | Dec 9, 2022 | Research

Often, investing strategies are simple to understand, but the opaque names and jargon that surround them can leave you feeling excluded from the conversation. That’s why we strive to make investing approachable. One of the ways we accomplish this is by defining commonly used terms, so you can participate in financial conversations and make decisions with confidence.

Dollar cost averaging is a common investing strategy that can reduce risk and even lower your tax bill. Despite its formal-sounding name, it’s easy to understand and simple to implement.

What is dollar cost averaging?

Dollar cost averaging is the process of investing a fixed amount into a particular security over a series of time periods, regardless of purchase price.

To implement this strategy, set a monthly budget, then choose a stock (or another investment) that you believe will be a long-term winner. Each month, purchase the planned amount of your chosen investment, regardless of how it is performing at the time. Over time, you will have a collection of different shares at different price points ­– each of these purchases represents a “tax lot” – more on this later.

Definition of Dollar Cost Averaging

With dollar cost averaging, you vary your purchase price, also known as “cost basis”, over time. For example, if you invested $100 into a stock every month, you would likely purchase a different number of shares at a different price each time you buy.

Dollar Cost Averaging Informational Graphic

Why dollar cost average?

Dollar cost averaging can be beneficial for a variety of reasons. Namely, it can help reduce the risk of buying at a stock’s height and aid in tax planning.

Reducing Purchase Price Risk

There are two main alternatives to dollar cost averaging – investing all available funds as soon as possible or attempting to time the market. Both strategies have drawbacks.

If you buy a stock as soon as the funds are available, you risk making a large purchase at a stock’s height. However, with dollar cost averaging, you avoid this risk by purchasing at many different prices.

Market timing – or waiting to purchase until you believe a stock is at its lowest point – is often called a “fool’s errand.” You can make educated guesses about a stock’s future price by analyzing its past performance and key metrics, but even the best estimates can be wrong. With dollar cost averaging, you save time spent predicting a stock’s price and avoid making an untimely purchase based on bad information or incorrect analysis.

If you wait to purchase a stock until its price has fallen to a preferred level, funds could sit idly for months or even years. While cash is waiting to be deployed, you forfeit any potential gains. However, when utilizing the dollar cost average method, your funds begin working immediately.

Customizing Tax Consequences with Tax Loss Harvesting

Capital gains tax can be triggered when you sell shares for a profit. However, your tax liability is based on total gains for the year – so losses from one sale can offset gains from another.

The strategy of intentionally realizing losses to counteract gains is called tax loss harvesting and it is often used in conjunction with dollar cost averaging. As mentioned earlier, dollar cost averaging creates many different “tax lots.” While it’s important to understand that you should avoid selling an investment for tax purposes alone, these lots can be manipulated to your advantage for taxes.

What is tax loss harvesting?

When reducing holdings in a particular investment, you can sell or “harvest” the worst performing lots to offset other gains. This results in 2 desirable outcomes – shrinking your position and reducing your tax liability. Conversely, if you had significant losses from other investment sales, you could harvest gains as well. You’d do this by selling the best performing lots – ridding yourself of the unwanted, highly-appreciated shares – while you have other losses to offset them.

Dollar cost averaging can be beneficial in many situations, but it is always important to discuss your investing strategy with an experienced, fiduciary financial advisor. An advisor can help you choose advantageous investments and determine which strategies could help you reach your individual goals.

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Article Topics: Investment Advice | Stocks