Dollar Cost Averaging: Definition, Formula, Examples

By AJ Smith · May 18, 2024 · 7 minute read

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Dollar Cost Averaging: Definition, Formula, Examples

Dollar cost averaging is a way to manage volatility as you continue to save and build wealth. Volatility is a natural part of investing. Virtually every part of the market is impacted by volatility in one way or another — thus, nearly every investor must contend with inevitable price fluctuations, and one way to do this is by using 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 the interval you choose), and then ideally automate that amount to be invested on a regular basis.

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)?

Dollar cost averaging is a basic investment strategy where you buy a fixed dollar amount of an investment on a regular basis (e.g. weekly or 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.

That’s because with dollar cost averaging (DCA) you invest the same dollar amount each time, so that, effectively, when prices are lower, you buy more; when prices are higher, you buy less. Otherwise, you might be tempted to follow your emotions and buy less when prices drop, and more when prices are increasing (a common tendency among 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 Stock A every Monday, 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 Stock 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 Stock 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.

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 their regular $200 investment gets them six shares.

Investor B now owns 22 shares of the ETF, at an average price of $40.90 per share, compared with Investor A, who paid $1,000 ($50 per share for 20 shares) in one lump sum.

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Benefits and Disadvantages of DCA

Every strategy has its pros and cons, of course. Here are some of the advantages and disadvantages of DCA.

Dollar Cost Averaging Benefits

DCA forces you to stay the course, regardless of volatility. It keeps you from trying to “time the market.” By investing the same amount of money every month, you will buy more shares when the market is down and fewer shares when 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 automate. You don’t have to 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 growing an investment portfolio.

Dollar Cost Averaging Disadvantages

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 — including the impact of fees, of selling when the market is down and locking in losses, and so forth — 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 — and 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.

Last, dollar cost averaging doesn’t solve the problem of rebalancing — another strategy that’s designed to mitigate volatility.

💡 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.

•   For example, many people believe they need to invest large sums of money to invest successfully. In fact, DCA is evidence that you can invest small amounts, steadily over time, and reap the benefits of market growth.

•   Funds: Mutual funds allow you to purchase a share, which 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.

•   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.

The Takeaway

Dollar cost averaging is a fairly straightforward strategy that can help mitigate the impact of volatility on your portfolio, and also help you avoid giving into emotional impulses when it comes to buying or selling. Thus, dollar cost averaging can help you stay in the market, even when it’s fluctuating, with the result that you buy more when prices are low and less when prices are high — but 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, it’s wise to rebalance your portfolio to restore your original asset allocation (unless of course your risk tolerance or goals have changed).

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FAQ

Is dollar cost averaging a good idea?

Dollar cost averaging may be a good strategy for many investors to employ, as it has certain advantages that beginner investors, in particular, may use to their benefits. But it’s important to consider the downsides or disadvantages, too.

When is the best time to do dollar cost averaging?

There isn’t really a bad time to use a dollar cost averaging strategy, as such, investors interested in implementing one could likely do it at nearly any time.

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 weekly investments, while it may involve daily or monthly investments for others.

Where is dollar-cost averaging most commonly done?

Dollar cost averaging is a strategy commonly used in retirement plans, such as 401(k)s, although it can be used in various types of investment accounts.


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