Dollar cost averaging is essentially 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.
Dollar cost averaging has some other benefits as well. Keep reading to learn more about how dollar cost averaging might serve your long-term financial plan.
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 cadence (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 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 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).
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.
Recommended: How Much Stock Volatility is Normal?
How Does DCA Work?
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
For example, Investor A might buy 20 shares of an exchange-traded fund (ETF) at $50 per share, for $1,000 total.
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.
Dollar Cost Averaging, Long Term
As you can see in the example below, over time the price per share of almost any security will fluctuate up and down. In this hypothetical, the price ranges from $22 to $27 per share over the course of six months.
By contributing the same amount every month, though, you end up buying more shares when the price is low and fewer shares when the price is high — which contributes to a higher overall valuation for the shares held in this hypothetical example.
|Fund A price||Amount invested||Shares bought||Shares owned||Total value|
|Dollar cost average||Total invested||Total # of shares||Investment value||P/L|
Benefits and Drawbacks of Dollar Cost Averaging
Every strategy has its pros and cons, of course. Let’s look at the advantages and disadvantages of DCA.
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 — or inertia, as many behavioral studies have shown.
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 plan.
You 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.
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. More on that below.
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.
7 Mistakes To Avoid When Dollar Cost Averaging
Although it’s a fairly simple strategy, it pays to know the pitfalls so you can avoid them.
1. Failing to Start Early
Dollar cost averaging instills investing discipline, which is a valuable lesson to learn early on. When you’re first starting out, it’s often difficult to take a long view of your future.
However, making dollar cost averaging a priority from the start, and opting for regular, automatic investments that you don’t even have to think about, will get you on your way with a minimum amount of effort and stress.
2. Not Investing Consistently
Waiting for the market to change before taking action is going to make your contributions uneven and ultimately ineffective. A stop-and-start approach means that you will need to pay more attention to the investment, whether you have the time to do so or not. Dollar cost averaging solves for that problem, as long as you stick to it.
3. Forgetting to Diversify
In order to help reduce volatility, it may be a good idea to keep your stock portfolio diversified. As the market changes, your original game plan for your overall portfolio (as opposed to just one stock) may need to be reviewed and altered to adjust to changes in the market.
4. Trying to Time the Market
If you watch the markets ups and downs, and you think it may be time to give dollar cost averaging a rest, you could become a slave to trying to time the market. Most financial professionals discourage this because of the risks of making impulsive choices that can lead to unwanted risk or even losses.
5. Confusing DCA With Ignoring Your Portfolio
The dollar cost averaging strategy is not meant to run on auto-pilot. You will need to periodically review your investments to see if you need to alter your plan.
Ideally, you should review your plan annually to make sure your investment strategy still aligns with the amount of risk you are comfortable taking and that you are saving enough to meet your goals.
6. Not Investing a Lump Sum If You Have It
If you have a lump sum to invest, e.g. a bonus, tax refund, or gift, it’s best to invest it all at once, rather than try to do dollar cost averaging and divide it into 12 monthly installments. Cash not invested will not be working for you.
7. Ignoring Trading Costs and Transaction Fees
It depends on your broker or financial advisor, as well as the type of account you have, but pay attention to the fees you pay. Investment expenses add up, and can affect your total returns over time.
Rebalancing Your Portfolio
The periodic rebalancing of your portfolio is easy to overlook, but it’s an important and valuable task.
The concept of rebalancing is actually very similar to dollar cost averaging. Dollar cost averaging is the steady investment of money on a regular basis whether the market is up, down, or even. This can result in a lower average cost per share over the long term.
Rebalancing is simply taking a similar approach but applying it to your overall investment portfolio. Another term for this is asset reallocation, or adjusting the percentages of how much of your money is invested where. Typically this process starts by grouping investments together with other similar investments called asset classes.
Asset classes include U.S. stocks, international stocks, high-yield bonds, real estate, short-term treasury bonds, and more. The money you put into these asset classes should be divided up according to your goals and comfort level.
That means that at the end of the day, your portfolio should ideally be sticking to your original plan and goals, and continuing to adhere to your risk tolerance and timeframe (like retirement, for instance). It’s simply a periodic fine tuning.
On the surface, the basic process of rebalancing just sounds wrong: selling off the asset classes that outperformed your expectations, and using that money to buy more of an asset class that didn’t do as well.
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.
Also, anyone can use DCA, and you don’t need a lot of money because the whole idea is to invest the same amount at regular intervals (even if that’s a small amount).
That said, 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).
You can get started implementing your own approach to investing using dollar cost averaging when you open an online brokerage account with SoFi® Invest. SoFi offers an active solution for do-it-yourself investors. You can set up your account to make regular investments — and SoFi doesn’t charge any management fees.
SoFi also offers an automated solution for investors who want a diversified strategy. Either way, as a SoFi member you will have access to financial professionals who can answer your questions and help you along the way.
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