There’s more than one way to invest. Besides choosing a vehicle to put your money into, you’ll need to pick an investing strategy. The one that you select will depend on various factors, including your target asset allocation and the kinds of returns you want to see. If you’ve never heard of dollar-cost averaging, we’ll review how this investing technique works.

Dollar-Cost Averaging: The Basics

So what is dollar-cost averaging? Also referred to as the constant dollar plan, it’s the process of investing a specific dollar amount in a security according to a set schedule. The number of shares you purchase each time depends on the share price.

In other words, when the share price seems high, you’ll invest a fixed amount of money in a small number of shares. When the price falls, you’ll invest the same dollar amount as before but you’ll buy more shares. Through dollar-cost averaging, you can buy a lot of shares and even as the cost per share changes, the average cost you’ll pay per share will go down with time.

Let’s look at an example. Say you want to invest $10,000 in a stock but you don’t want to invest all of that money at one time. With dollar-cost averaging, you can spread out that investment. For instance, you could invest $2,500 every three months.

When shares are cheap, you might pay $2,500 and buy 200 shares. But if the price rises in the third quarter, you could use your $2,500 and buy just 80 shares.

The Purpose of Dollar-Cost Averaging

Investing can be scary because it’s impossible to time the market perfectly. Even the most seasoned investor might not be able to predict a dip or a downturn in a particular sector. When you’re investing in something as risky as stocks, you’ll inevitably deal with volatility.

Dollar-cost averaging is a strategy that’s meant to make investing less frightening and less dramatic. Investing small amounts of money in fixed increments over time isn’t as risky as investing a large sum of money at once. And since you’re investing regularly, you don’t have be so concerned with how the market’s performing.

So going back to our example, regardless of whether there’s a bear market or a bull market, you’d invest your $2,500 in stocks each quarter if you were on a constant dollar plan. Thanks to the consistency embedded within the strategy, you can save time by automating your investments.

When Dollar-Cost Averaging Works

While you can use dollar-cost averaging to invest in everything from stocks and bonds to mutual funds, it won’t work well with every single asset.

It’s best to use this strategy when you’re investing in a security whose prices often fluctuate. For example, dollar-cost averaging can be beneficial to someone who’s buying ETFs, mutual funds or stocks. On the other hand, it’s not so helpful for folks investing in securities like bonds.