Dollar-Cost Averaging Into the S&P 500: Does It Really Work?

Dollar-cost averaging (DCA) attempts to mitigate the emotional aspect of investing by taking some of the choice of when and how much to invest in a particular security out of the hands of the investor. With DCA, investors pick a target security and invest a fixed amount of money at regular intervals, regardless of what the price of that security is at any given time. DCA is a tool to limit risk.

While DCA can work for any security, many investors apply this technique to an investment in the S&P 500 Index, a broad collection of around 500 large-cap U.S. companies collectively representing about 80% of total market capitalization.

Understanding Dollar-Cost Averaging

The function of DCA as an investment strategy is that it ensures investors do not try to “time the market” by investing at times that seem opportune (such as when the price of a security is low, or in the midst of a rally). Investors may specify a particular target security and a total amount of money that they would like to invest; they then divide that sum into equal portions to be invested at regular intervals.

Even the most experienced investors are subject to psychological traps such as the disposition effect, in which an investor tends to hold on to losing investments too long and sell winning investments too soon.

Implementing Dollar-Cost Averaging Into the S&P 500

Because it is not possible to invest in the S&P 500 Index directly, an investor looking to apply DCA to the S&P 500 must first select an index or exchange-traded fund (ETF) tracking this collection of stocks. Fortunately, these funds are plentiful and often quite inexpensive and include major players like the SPDR S&P 500 ETF Trust (SPY) or the Fidelity 500 Index Fund (FXAIX).

To implement a DCA strategy with one of these funds, an investor may first want to decide how much to invest in total, what the total timeframe for the investment will be, and how often to contribute to the investment. Say you wish to invest $10,000 in the SPY over a period of 10 months, with one investment on the first day of each month. You would then invest $1,000 each month, regardless of the price of SPY on that day.

An advantage of using a broad-based S&P 500 fund like SPY is that it captures a wide swath of the market. Because it is already diversified, it limits the risks associated with investments in individual stocks. DCA further helps to reduce these concerns.

Historical Performance Analysis

Nuveen, the asset management company, completed an assessment of the historical performance of a hypothetical DCA approach to investing in U.S. stocks. If an investor put $500 each month into this investment from 2000 to 2020—an investment of $120,000 total over a 20-year span—they would achieve a total accumulation of $280,801 during that time.

By contrast, consider a lump-sum investment of the same principal. An investor buying $120,000 worth of the SPY at the beginning of 2000, at a price of $94.20 per share, would have ended up with about 1,273 shares. Based on a closing price of $352.05 on December 31, 2020, those shares would be worth $448,159.65. However, this does not account for management fees accrued over the 20-year period, nor does it include dividend reinvestments.

For example, cashing out on March 27, 2020, not quite a full 20 years into the lump-sum investment, would yield around $305,847, again not counting management fees or dividends.

Advantages of Dollar-Cost Averaging

One of the key benefits of DCA is mitigating the price risk associated with attempting to time the market. Historically speaking, investors trying to time the market tend to miss some rallies. DCA ensures that you can capture those gains. It may also help to reduce emotional decision-making and to lower average purchase prices for a particular security.

Because the best days of the market often come at times of significant volatility—when investors may be cautious—dollar-cost averaging helps reluctant investors to still benefit during those periods.

Beyond that, DCA can be helpful for investors lacking a sizable amount of capital to put toward an investment up front. By spreading an investment out across multiple contributions, they may make the process of investing more accessible.

Potential Drawbacks and Considerations

That said, DCA does have some limitations alongside its benefits. Investors using DCA may forfeit higher returns, particularly in times when the market is consistently rising. Think of it this way: with DCA, an investor is holding a higher percentage of an investment as cash for a longer time. This reduces risk, but also means they can miss out during an extended rally.

Beyond that, fees may be a factor as well—a dollar-cost averaging strategy that invests a small amount of money in a security every day, for example, might lose a sizable portion of its capital to transaction fees.

Setting Up a Dollar-Cost Averaging Plan

Setting up a DCA plan with your brokerage account is fairly straightforward. Follow these steps to do so:

1. Set up and fund a brokerage account if you do not already have one.
2. Determine the security or securities you wish to target. While DCA can work for many different securities, a common approach is an S&P 500-focused fund as described above.
3. Decide the parameters of your investment: how much money do you wish to invest in total? How often and when will you contribute? Keep in mind, of course, that more contributions may mean more fees.
4. If your brokerage allows automatic investment setups, you may be able to specify the upcoming portional investments ahead of time and let the system take care of the rest. If not, set yourself a reminder for each installment to be sure that you contribute regularly.

There is not necessarily a benefit to using an automatic or a manual contribution strategy, though some investors may find that setting automatic contributions makes them less likely to accidentally forget to make an investment when the time has come.

The Bottom Line

Dollar-cost averaging spaces an investment out over time, re-allocating it into smaller portions made at regular intervals. Many investors find that DCA helps them to avoid trying to time the market and allows them to capture gains from rallies that take place during volatile periods in which they may otherwise be disinclined to invest. A DCA approach with a fund linked to the S&P 500 may be suitable, given that the market trends upward over time. DCA may also be more accessible for many investors who lack the capital available to make lump-sum investment payments.

On the other hand, lump-sum investments in funds that tend to grow fairly steadily may outperform DCA strategies over time because a larger portion of the investment principal is exposed to market growth conditions for longer. This approach also consolidates the number of transactions, potentially helping to reduce fees.

If you’re an investor who tends to react emotionally to market news—or even if you don’t suspect that you do—or someone wishing to take the timing element out of consideration when you approach your investments, DCA may be a good option for you.