Dollar cost averaging is a long-held investment thesis that states you should consistently buy shares of a security in equal amounts, regardless of its current price. This will allow you to purchase more shares of an investment at low prices and fewer shares at high prices.

The net effect is a steady averaging of your cost basis over multiple months and years, which (it is assumed) will allow you to participate in stable growth.

There are obvious pros and cons for this strategy that should be evaluated in the context of your investment goals, income needs and experience. Let’s dive in and see who this methodology benefits and who may want to rethink the need for a dollar cost averaging plan.

Example 1: The Passive Wealth Accumulator

Those investors that are saving for retirement or working to accumulate wealth for a foreseeable future event may be dollar cost averaging without even knowing it.

Most 401(k) or 403(b) plans allow you to select a model portfolio of holdings and then contribute to those same funds on a perfectly consistent basis (i.e. pay day).

The benefit to this strategy is that money is automatically set aside for investment purposes and placed in an account with the goal of compounded growth. If you are one to set your portfolio on auto-pilot with very little interaction other than quarterly or annual reviews, then this strategy will likely work well for you over time.

The ability to continually put capital to work regardless of price has historically been a winning strategy as long as the holdings are balanced among various asset classes.

Index mutual funds and exchange-traded funds make perfect vehicles for this strategy because they allow you to add money in diversified baskets with extremely low turnover and costs.

In addition, many brokerage companies now allow a subset of ETFs to be purchased commission-free. This removes the barrier to entry and can allow for efficient long-term wealth accumulation.

Example 2: The Retired Income Generator

When you reach the age or life event that entails flipping your investment strategy from growth to income, the need for dollar cost averaging may not apply anymore.

Instead of putting money into your portfolio, you will likely be looking to live off the proceeds and dividends generated by the underlying holdings.

In this scenario, it will be more important to focus on your asset mix in order to generate the yield required for living expenses. Furthermore, capital preservation during bear markets will be another chief consideration.

If you don’t require the income immediately, it may make sense to incrementally add to your existing holdings at opportune times (i.e. dips) or have the dividends automatically reinvested for you. The latter option may still be considered somewhat of a dollar cost averaging even if you are consistent with a reinvestment plan.

Example 3: The Active Investor

Active investors are going to be the ones who point out the flaws in the dollar cost averaging strategy. They will hold in contempt the advice to consistently buy an investment as it falls without any strategy of how it will recover.

To an active investor, dollar cost averaging ignores specific market and business risks that can wreak devastating effects on your portfolio.

They will also say that pouring money into an investment that is trending higher will just average your cost basis up along with it. The true path to wealth generation is to buy low and sell high — not the other way around.

Nevertheless, even active investors have been known to average into trades by breaking up their allocations into smaller blocks to take advantage of time and price. This allows them to commit a small portion of their portfolios in incremental moves rather than throwing caution to the wind by putting a large percentage of money to work all at once.

This tactic is a well-known risk and cost basis management technique that many traders use successfully.

Bottom Line

Dollar cost averaging will be most advantageous to passive investors in the growth phase of their assets using low-cost and diversified ETFs. If you plan on taking income or making significant changes to your holdings along the way, then you may want to hold off on implementing a strategy of this nature.

Either way, having a disciplined and well-balanced investment approach is imperative to a successful outcome.