How a Set-It-and-Forget-It Approach to Fund Investing Can Yield Powerful Returns
Fact checked by Suzanne Kvilhaug
Reviewed by Julius Mansa
Dollar-cost averaging (DCA) is a popular strategy among mutual fund and exchange-traded fund (ETF) investors. With this approach, you invest fixed amounts of money regularly, regardless of market conditions, potentially reducing the impact of market volatility on your portfolio.
“Systematically buying investments incrementally over time is a proven method to a successful long-term outcome because it helps you ignore the noise of financial news and the folly of attempting to time the market,” said David Tenerelli, a certified financial planner at Strategic Financial Planning in Plano, Texas.
Below, we’ll explore why dollar-cost averaging with ETFs is often a smart move as part of your investing strategy.
Key Takeaway
- Dollar-cost averaging involves a series of periodic investments on a regular schedule, such as weekly, monthly, or quarterly.
- ETFs, now with commission-free trading at many brokerages, are often used as part of a DCA strategy.
- DCA with ETFs allows for diversification and regular investing in various market sectors or indexes.
- When evaluating funds for DCA, consider expense ratios as part of your returns.
- DCA with ETFs allows for diversification and regular investing in various market sectors or indexes.
How Dollar-Cost Averaging Works With ETFs
DCA is an investment strategy where an investor regularly purchases a fixed dollar amount of a particular asset, regardless of price. This helps mitigate the impact of market volatility by spreading out purchases over time, potentially lowering the average cost per share and reducing the risk of investing a large sum all at once.
With DCA, you invest a fixed amount of money regularly, regardless of market conditions. When applied to ETF investing, this approach can offer several advantages, not least that ETFs generally provide instant diversification.
A single fund can give you exposure to hundreds or even thousands of stocks or bonds, spreading your risk across multiple securities. Popular choices for DCA include broad market ETFs that track indexes like the S&P 500 or total stock market, but you can also use this strategy with sector-specific or international ETFs to build a more customized portfolio.
In addition, using DCA for investing in ETFs can help you overcome emotional barriers to investing. It removes the pressure of trying to “time the market” and can make it easier to stick to an investment plan during market downturns. However, it’s important to note that while DCA can reduce the impact of short-term market volatility, it doesn’t guarantee profits or protect against losses in declining markets.
Many studies going back decades have shown what most stock market professionals will tell you: It’s unwise to try to “time the market,” which is notoriously difficult for even the best traders.
Example of DCA with an ETF
Suppose you started investing in the SPDR S&P 500 ETF (SPY) at the beginning of 2018. Instead of trying to time the market, you decided to use a disciplined strategy of putting away $1,000 at the beginning of each month, regardless of the price of SPY.
Below are three charts:
- The first illustrates the price fluctuations of SPY from 2018 to 2024. Over this period, the price had significant shifts because of market volatility, with some sharp drops followed by sustained growth, especially after the lows of 2020.
- The second chart shows how the number of shares you could buy with your $1,000 changed. When the price of SPY was lower (such as during the 2020 downturn), your $1,000 bought more shares. As the market recovered and the price of SPY increased, your $1,000 bought fewer shares each month. This demonstrates how DCA allows you to accumulate more shares during lower-priced periods, balancing out the cost over time.
- The final chart shows the value of the shares over time, showing how much you altogether accumulated for the last month in this period.
By sticking to this strategy, you avoid the pitfalls of trying to time the market and cut the risk of making large purchases at high prices. Over the period from 2018 to 2024, your total investment would have been $81,000 (i.e., $1,000 per month for 81 months). However, thanks to the rising price of SPY and the power of consistent investing, the value of your holdings would now be over $128,000—showcasing the long-term growth potential of DCA.
Note
A major advantage of using DCA with ETFs is the ability to start investing with relatively small amounts while still gaining exposure to a wide range of assets
Comparing ETFs for Dollar-Cost Averaging
When using a dollar-cost averaging strategy, choosing the right ETFs for your goals and risk tolerance is important in making each dollar count. While the strategy itself helps manage market timing risk, the ETFs you select will determine your portfolio’s overall exposure and potential for growth.
“When dollar-cost averaging into ETFs, investors should consider the index that the ETF tracks and whether it’s a good fit for their portfolio, as well as all relevant fees,” Tenerelli said. “This includes not just the expense ratio of the ETF but also the average trading bid/ask spread and whether they might be paying a premium for the shares relative to the net asset value of the ETF.”
Here are some of the factors to consider when comparing ETFs for your DCA plan:
Assets under management: Generally, larger funds tend to be more liquid and have lower bid-ask spreads, which can cut your trading costs. Funds with at least $1 billion in AUM are usually sufficiently liquid for most investors. For those tracking the major indexes, they are often well above this amount, and so this, like trading volume, isn’t generally a concern.
Diversification: Look for ETFs that offer broad market exposure. Many investors start with ETFs tracking major indexes like the S&P 500, which provides instant diversification across 500 of the largest U.S. companies. For even broader exposure, you might consider total stock market ETFs that include small and mid-cap stocks.
Dividend yield: If generating income is part of your strategy, consider the ETF’s dividend yield.
For DCA investors, reinvesting your ETF dividends can help compound your returns over time and boost your investment’s growth.
Expense ratio: This is the annual fee charged by the fund, expressed as a percentage of your investment. Lower expense ratios mean more of your money stays invested. For broad market index ETFs, look for expense ratios below 0.10%.
Tracking error: This measures how closely the ETF follows its benchmark index. A lower tracking error indicates the fund is doing a good job replicating the index’s performance.
Trading volume: A higher average daily trading volume typically means better liquidity and easier buying and selling at fair prices.
For those new to investing, starting with one or two broad-market ETFs can be an excellent way to begin. As you become more comfortable, you might consider adding ETFs focusing on specific sectors, geographic regions, or asset classes to diversify your portfolio further. Below are some popular choices, though there are many others to review that might fit your needs better when starting out.
How Many ETFs Are Available for Investment?
Investors had 3,108 ETFs available to them as of December 2023. But that number increased significantly in 2024 after the U.S. Securities and Exchange Commission approved 11 spot market bitcoin ETFs in January 2024, and a generally bullish market invited other funds into the picture.
What Is an Index Fund?
An index fund is a type of investment fund designed to track the performance of a specific market index, such as the S&P 500 or the Nasdaq Composite. Instead of trying to beat the market through active stock picking, index funds aim to match the market’s performance by holding the same securities in the same proportions as the target index. This passive investment approach typically results in lower fees and better long-term performance than many actively managed funds. Index funds can come in the form of mutual funds or ETFs.
What Are the Most Popular Types of ETFs?
In 2024, collating data from the Investment Company Institute, broad U.S. equity index funds made up about 55% of assets under management by ETFs, followed by bonds at 17%, global equity index funds at 16%, sector-focused ETFs at 9%, commodity ETFs at 1.5%, real estate-related ETFs at 0.8%, with crypto-related ETFs at 0.7%.
Are ETFs More Tax-Efficient Than Mutual Funds
In the last few decades, fees have dropped significantly for mutual funds and ETFs, though more for mutual funds. ETFs still enjoy an advantage over mutual funds in tax efficiency due to their creation/redemption process. When investors buy or sell ETF shares, these transactions occur on an exchange between investors. The ETF itself doesn’t have to sell underlying securities to meet redemptions, which helps minimize taxable events.
In contrast, mutual funds often need to sell securities to meet investor redemptions, potentially triggering capital gains distributions that are taxable to all shareholders, even those who haven’t sold their shares.
However, not all ETFs are more tax-efficient than all mutual funds. Index mutual funds, for instance, can be quite tax-efficient because of their low turnover. In addition, in tax-advantaged accounts like 401(k)s or individual retirement accounts, the tax efficiency of ETFs becomes less relevant.
The Bottom Line
Using DCA to invest in ETFs is a potent way for long-term investors seeking to build wealth while managing risk. This approach combines DCA’s disciplined, consistent investing with ETFs’ diversification and tax efficiency, creating an accessible path to potentially smoother returns over time.
When choosing ETFs for dollar-cost averaging, financial advisors suggest building a core portfolio first, starting with broad market ETFs before adding more specialized funds. While this won’t guarantee profits or eliminate risk, this approach can help reduce the impact of market volatility and help you build a diversified portfolio with relatively low costs.