Dollar-Cost Averaging & ETF: How They Build Wealth Over Time

The easiest way to make a fortune in the stock market is to buy shares of great companies at the lowest possible price and hold them for the long term. The difficulty is knowing when they are at these lows. 

Research from Schroders shows that if you remained fully invested from 1986 to 2021, a £1,000 investment in the FTSE 250 would have grown by 11.4% per year. If you missed the ten best days in the market, the investment would earn 9.5% annually. The 1.9 percentage point difference almost halves your returns over this time: £43,595 versus £24,156. The results are even more shocking if you miss the best 20 and 30 days.

So, how can I avoid missing out on the best days in the market? And how can I grow my wealth without trying to time when stocks are at their lows? 

Dollar-cost averaging and exchange-traded funds (ETFs).

Here’s everything you need to know about them.

What is Dollar-Cost Averaging?

Dollar-cost averaging is an investing strategy where you invest the same amount of money into an asset over regular periods. It helps investors spread out their investment purchases and reduces the likelihood of engaging in timing the market.

Dollar-cost averaging is an easy and popular investing method often used with exchange-traded funds (ETFs). It helps investors remove their emotions from investing and weather short-term market volatility through systematic purchases. Depending on how regularly an investor chooses to invest, dollar-cost averaging helps them take advantage of any price declines – they receive more shares per purchase and reduce their cost basis (the cost basis concept is explained here).

Exchange-Traded Funds (ETFs) Explained

Exchange-traded funds are passively managed funds that track indices like the FTSE 100 and S&P 500, sectors like the information technology sector, and commodities like silver and gold. The stocks in an ETF are set based on the allocation in the index that the ETF tracks. ETFs are regularly reviewed and adjusted for any changes in the index or sector. 

When people think about investing in ETFs, they mainly look at the index it tracks, the companies in the fund, and the dividend yield, but hardly at the expense ratio.

Expense Ratios And Their Impacts

Expense ratios are the fees investors are charged for buying an ETF. This may be the most important thing to research before investing in any fund because it can significantly hurt returns in the long run. 

The Vanguard Group is the world leader in low-cost index funds, so it only makes sense to turn to them to understand the impacts different expense ratios can have on investment returns.

Based on a $500,000 investment growing at 6% annually, investors can save $33,000 in fees over ten years, $115,000 over twenty years, and $300,000 over 30 years by investing in a low-cost index fund versus a high-cost one.

This study used Vanguard’s average expense ratio of 0.08% and the industry’s average of 0.44%. 

Although the difference in expense ratios is just under half a per cent, we see the impacts it can have. After 30 years of investing in a low-cost fund versus a high-cost one, an investor can be $300,000 better off. 

The closer a fund’s expense ratio is to 0%, the higher your returns.

How Does Dollar-Cost Averaging Work?

Dollar-cost averaging smoothens out investment purchases since share prices constantly fluctuate. When share prices rise, your cost basis increases as you buy. As share prices fall, your cost basis decreases as you buy. Therefore, the share price dictates your cost basis.

Another way of saying ‘cost basis’ is ‘average cost per share.’

Dollar-Cost Averaging Example

Let’s say you invest £100 per month for six months into a low-cost ETF whose share price fluctuates between £10 and £16 per share.

As the share price falls in the first three months, the number of shares you receive per purchase increases. The more shares you receive per purchase, the lower your cost basis. When the share price increases in the fourth month, the opposite occurs. You receive fewer shares per purchase, and your average cost per share rises. 

This is dollar-cost averaging at work.

After six months of dollar-cost averaging, you would make £60.89 or a 10.15% investment return.

Dollar-cost averaging is a good investing strategy because you don’t need the share price to rise above the price you originally bought to make money. Once you buy shares as the price falls, you only need the share price to be above your average cost per share. 

How Investors Use Dollar-Cost Averaging

Dollar-cost averaging is a simple strategy often used by passive investors. Whether they invest £100 a month, £10 a week, or £10,000 twice a year, they are all considered dollar-cost averaging. 

So, how do investors go about dollar-cost averaging in their portfolios?

Planning

They decide how much money they will invest and how often they will invest it. In analysing their finances and setting an investing time horizon, investors reverse engineer how much and how often they will invest. 

Choosing

Dollar-cost averaging can be used with various securities, including stocks, mutual funds and exchange-traded funds. Investors often favour ETFs because of their low fees (compared to mutual funds) and low volatility (compared to stocks). 

Investing

Once investors have planned and chosen their desired security, they begin dollar-cost averaging. Some investment apps allow investors to automate their purchases, only requiring a routine account top-up to fund the purchases. Investors must buy shares manually on platforms without this function.

Dollar-Cost Averaging Advantages & Disadvantages

Like all investing strategies, there are pros and cons to dollar-cost averaging with ETFs.

Pros of Dollar-Cost Averaging

Minimal research

Most of the research is done by the ETF provider. They research and allocate capital to mimic the index the ETF is intended to track. As an investor, the remaining research should revolve around factors like the fund’s expense ratio, dividend yield, and the companies in it.

Removes emotions from investing

Since dollar-cost averaging requires regular investing, investors keep accumulating shares regardless of price (as long as it makes sense to). This way, they won’t panic sell when the market declines but see it as an opportunity to purchase cheaper shares and lower their cost basis.

Own the best companies with little risk.

When investors buy ETFs, they own small pieces of companies in it, thus diversifying their portfolio. Because they aren’t exposed to the individual companies, if one company has a poor couple of months, it won’t significantly impact their portfolio’s performance.

Growing with the market

If an investor buys an ETF that tracks the UK market, their investment will grow in line with it. This is the same if they buy an ETF that tracks a particular sector or commodity.

Cons of Dollar-Cost Averaging

Limited returns

Dollar-cost averaging in ETFs limits an investor’s returns to that of the index. If an index returns 5% annually, so will the ETF that tracks it. 

Higher brokerage fees

Frequent investing can trigger higher brokerage fees that erode investor returns over time. This erosion is particularly amplified if the investor invests small amounts regularly. To avoid this, investors should consider using a free investing platform.

Lump-sum investing may be better.

If an investor is dollar-cost averaging a large sum of money while the market is going up, they could miss out on portfolio gains had they invested all in one go (lump-sum investing). 

Dollar-cost averaging as the market rises increases your cost basis. When you lump-sum invest, your average cost per share remains the same, potentially increasing your returns over time. Lump-sum investing being better than dollar-cost averaging depends on factors including having a lump sum of money to invest and knowing that the market will continue rising. 

Summary

Dollar-cost averaging combined with exchange-traded funds (ETFs) offers a powerful strategy for long-term investors seeking to grow their wealth without the stress of market timing. By consistently investing a fixed amount, you can mitigate the emotional rollercoaster that often accompanies market fluctuations while benefiting from the potential of owning diverse, high-quality companies. 

While it’s crucial to be mindful of expense ratios and the inherent limitations of indexing, the advantages of this approach – including reduced emotional bias and the ability to take advantage of market dips – make it a compelling choice for many investors.

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