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Dollar cost averaging (DCA) is a way to help manage volatility as you continue to save and build wealth. Volatility is a natural part of investing, and nearly every investor must contend with the inevitable price fluctuations it can cause. One method for doing this is dollar cost averaging.
With this strategy, you decide on the securities you want to purchase and the dollar amount you want to invest each month (or whatever timeframe you choose), and then you automate that amount to be invested on a regular basis.
Read on to learn more about the DCA meaning, how this investment strategy works, and the pros and cons to be aware of.
Key Points
• Dollar cost averaging (DCA) is an investment strategy that helps manage volatility by investing a fixed dollar amount regularly.
• DCA involves buying securities at regular intervals, regardless of market prices, to avoid trying to time the market.
• Dollar cost averaging works by investing the same amount consistently, resulting in buying more shares when prices are low and fewer when prices are high.
• The strategy can help investors stay the course and avoid emotional decision-making based on market fluctuations.
• While dollar cost averaging has benefits like consistency and automation, it may not maximize returns compared to lump-sum investing and may not address the need for portfolio rebalancing.
What Is Dollar Cost Averaging (DCA)?
If you’ve been hearing about DCA and wondering, what is DCA exactly? This is what you need to know: Dollar cost averaging is an investment strategy where you buy a fixed dollar amount of an investment on a regular basis, such as monthly. The goal is not to invest when prices are high or low, but rather to keep your investment steady and repeatable, and thereby avoid the temptation to time the market.
With dollar cost averaging, you invest the same dollar amount each time so that when prices are lower, you buy more; when prices are higher, you buy less. Otherwise, according to behavioral finance theories, you might be tempted to follow your emotions and buy less when prices drop (investors can become more conservative in down markets), and more when prices are increasing (investors can be more optimistic and aggressive when the market goes up). These can be common tendencies among some investors.
How Dollar Cost Averaging Works
Dollar cost averaging works by making more or less the same investment over and over on a repeating basis. For an investor, it may be as simple as investing $5 in Fund A every other week (some investors might even think of Fund A as their DCA Fund), or something similar, no matter what’s going on in the market.
That way, you’re investing the same amount whether the market goes up, down, or sideways. For example, if you invest $100 in Fund A at $20 per share, you get 5 shares. The following month, say, the price has dropped to $10 per share, but you stay the course and invest $100 in Fund A — and you get 10 shares.
Over time, the average cost of your investments — the dollar amount you’ve paid — may end up being a little lower, which can benefit the overall value of your portfolio.
Dollar Cost Averaging Formula
When using a dollar cost averaging strategy, the formula for determining the average price paid per share of an investment over a certain period of time is simple:
Total Amount Invested / Total Number of Shares Owned = Average Price Paid Per Share
DCA investing is based on the assumption that prices may naturally rise and fall over time, allowing investors, as mentioned above, to buy more shares when prices fall and fewer shares when they rise.
As a result, a dollar cost averaging strategy may help investors reduce the average price they pay per share over time, potentially lowering their cost basis in investments. A common example of dollar cost averaging in practice is the regular investments made through 401(k) retirement plans, which are designed to help investors build their wealth in increments over several years.
That said, dollar cost averaging may not always reduce the average price paid, such as when the price of an investment rises steadily. Dollar cost averaging may also be risky when investing in fewer stocks as opposed to a well-diversified portfolio, for example, since an investor may not be aware when prices are falling steadily and they should potentially stop buying.
Example of Dollar Cost Averaging
Here’s an example of how dollar cost averaging might look in practice.
Investor A might buy 20 shares of an exchange-traded fund (ETF) at $50 per share, for $1,000 total. This would be investing a lump-sum, rather than using a dollar cost averaging strategy.
Investor B, however, decides to use a dollar cost averaging strategy.
• The first month, Investor B buys shares of the same ETF at $50/share, but spends $300 and gets six shares.
• The next month the ETF price drops to $30 per share. So Investor B once again invests $300 and now gets 10 shares.
• By the third month, the ETF is worth $50 per share again, and Investor B’s regular $300 investment gets them six shares.
Investor B now owns 22 shares of the ETF, at an average price of $40.90 per share and a total cost of $899.80.
Or, to use the DCA formula: $899.80 / 22 = $49.90
By comparison, Investor A, paid $1,000 ($50 per share for 20 shares) in one lump sum.
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Benefits and Disadvantages of DCA
Of course, every strategy has its pros and cons to consider. Here are some of the advantages and disadvantages of DCA.
Dollar Cost Averaging Benefits
One main benefit of DCA is that it requires you to stay the course, regardless of volatility. It keeps you from trying to time the market and trying to figure out how to know when to buy a stock. By investing the same amount of money every month, you will buy more shares if the market is down and fewer shares if the market is up. You’re not investing with your emotions, which can lead to impulsive choices.
DCA allows you to “set it and forget it.” Investing the same dollar amount every month is a straightforward strategy, and technology makes it easy to practice DCA as well as other types of automated investing. Though it’s always wise to review the performance of investments at regular intervals, with DCA, you don’t have to always keep your eye on different investments or even market volatility. Just stick to the plan.
You also don’t have to be wealthy in order to use the dollar cost averaging method. You can start small, but all the while, you will be contributing to and potentially growing an investment portfolio.
Dollar Cost Averaging Disadvantages
But there are some drawbacks to dollar cost averaging. In some cases, investing a lump sum may net you a higher return over time. Although DCA works well in terms of helping to manage the impact of volatility, the reality is that over the course of many years, the market trends upward, as the average market return shows.
Although there are many factors to consider when it comes to investing returns, the market’s upward trajectory is something to bear in mind.
When you use any kind of “set it and forget it” strategy, you run the risk of missing out on certain market opportunities. You can also miss out on any red flags. Although the upside of dollar cost averaging is its consistency, the potential downside is that you may be less aware if there are new opportunities — or the need to avoid losses.
In addition, if the price of the asset keeps rising, you’ll end up buying fewer shares than you would have if you’d purchase it at the lower price with a lump sum.
Last, dollar cost averaging doesn’t solve the problem of rebalancing a portfolio — which any investors might consider doing regularly to ensure their portfolio aligns with their risk tolerance.
đź’ˇ Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
When to Use Dollar Cost Averaging
There are certain times when dollar cost averaging makes sense, and certain investments that are suited to this strategy.
• Small and steady approach: For example, many people believe they need to invest large sums of money to invest successfully and they may have questions about buying and selling strategies, such as how long should you hold stocks. With DCA, an investor can invest small amounts steadily over time, and reap the potential benefits of market growth.
• Purchasing mutual funds: Mutual funds allow you to purchase a share that represents a very small allocation of the underlying investment portfolio. This means that you can diversify with much smaller dollar amounts than if you purchased the securities on your own.
• Investing in ETFs: (exchange-traded funds): Similar to mutual funds, ETFs provide an opportunity to diversify with smaller dollar amounts. Additionally, ETFs are available to trade throughout the day, generally have low expenses, no investment minimums, and may offer greater tax-efficiency.
Comparing Dollar Cost Averaging vs. Lump-Sum Investing
Both dollar cost averaging and lump sum investing have pros and cons. To help decide which option is best for you, consider your investment strategy and tolerance for risk.
New and experienced investors alike could potentially benefit from a dollar cost averaging strategy when investing in a diversified portfolio that experiences natural shorter-term volatility, while hopefully rising over time. A DCA investor may end up paying a lower price per share over the course of an investment.
Also, if market volatility makes you anxious and stresses you out, DCA could allow you to purchase assets and participate in the market in a small and consistent way that may make you feel more comfortable, while avoiding the risk of investing a large sum before a market downturn.
However, you may alternatively consider lump-sum investing if you have the funds available and can stomach some market ups and downs. Lump sum investing may give you a higher net reward over time, since the entire investment would have more time to potentially compound and grow than if the same amount were invested gradually over a longer time period. Depending on the brokerage you use, you may also reduce potential trading fees compared to DCA investing.
Keep in mind that the price you pay for the lump sum investment could potentially be higher (or lower) than if you used a DCA strategy since it’s extremely challenging to try to time the market.
Consider all the pros and cons carefully to decide which strategy makes the most sense for you.
The Takeaway
Dollar cost averaging is a fairly straightforward strategy that could help mitigate the impact of volatility on your portfolio, and may also help you avoid giving into emotional impulses when it comes to buying or selling. Thus, dollar cost averaging might help you stay in the market, even when it’s fluctuating, with the potential result that you could buy more when prices are low and less when prices are high. Overall, you may end up paying less on average.
But dollar cost averaging isn’t an excuse for literally “setting and forgetting” your portfolio. It’s still important to check on your investments in case there are any new opportunities or bona fide laggards. And once a year (or at whatever interval makes sense for you), you may want to rebalance your portfolio to help stay on track to meet your financial goals.
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FAQ
Is dollar cost averaging a good idea?
Dollar cost averaging may be a good strategy for some investors to employ, particularly beginner investors or those with a low tolerance for risk. That’s because it allows an investor to regularly participate in the market by taking a small and steady approach, it’s automatic and eliminates the need to try to “time the market,” and it helps take the emotion out of investing, which can prevent panic buying and selling.
But it’s important to consider the downsides of DCA, too. For example, lump sum investing may result in a higher return than dollar cost averaging over time.
When is the best time to do dollar cost averaging?
There isn’t necessarily a best time to use a dollar cost averaging strategy, but it can be a useful technique for those who want to consistently invest without spending a lot of time and effort on it.
How often should you do dollar cost averaging?
When using a dollar cost averaging strategy, investors can choose a cadence that is best suited to their overall financial goals. For some, it may involve biweekly investments; for others, it may involve monthly investments. Think about your financial goals and then choose an investment interval that makes sense.
Where is dollar cost averaging most commonly done?
Dollar cost averaging is a strategy commonly used in retirement plans, such as 401(k)s, in which money is automatically deducted from your paycheck and invested in assets you’ve selected. However, individual investors can use dollar cost averaging any time in their own individual investment accounts, such as a brokerage account.
What are the risks of dollar cost averaging?
The risks of dollar cost averaging may include a potentially lower return compared to lump sum investing since the latter essentially puts more money into the market sooner, giving it a longer runway to potentially grow should the investment rise over time. Overall, with dollar cost averaging, you may also be less aware of certain market opportunities or losses to avoid.
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Dollar Cost Averaging (DCA): Dollar cost averaging is an investment strategy that involves regularly investing a fixed amount of money, regardless of market conditions. This approach can help reduce the impact of market volatility and lower the average cost per share over time. However, it does not guarantee a profit or protect against losses in declining markets. Investors should consider their financial goals, risk tolerance, and market conditions when deciding whether to use dollar cost averaging. Past performance is not indicative of future results. You should consult with a financial advisor to determine if this strategy is appropriate for your individual circumstances.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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