Defining dollar-cost averaging (DCA)
Dollar-cost averaging, also known as DCA, is a method for making market investments. It depends on making relatively minor purchases on a regular basis as opposed to all at once.
For instance, if someone receives a bequest of $120,000, they might invest the entire sum right away by buying shares for $120,000, or they could choose to dollar-cost average instead by making 12 purchases of $10,000 each over the course of a year.
Risk and volatility are restricted for investors using dollar-cost averaging. It can lessen losses because if the value of a security drops after an investor makes a significant one-time investment, the investor stands to lose a lot of money. Average dollar costs put a stop to that. However, if a stock is increasing in value but the investor is holding onto cash for upcoming purchases rather than investing his or her entire balance right away, it can also diminish returns.
DCA investing is advantageous for new investors as well as those with limited resources. Investors can adopt dollar-cost averaging, investing little amounts over time, rather than delaying until they have a sizable balance.
How does dollar-cost averaging work?
An investor can employ the straightforward strategy of dollar-cost averaging to accumulate savings and wealth over time. Additionally, it gives investors a means to disregard recent market volatility.
The application of long-term dollar-cost averaging in 401(k) plans, where employees make regular investments regardless of the cost of the investment, is a prime example.
Employees who participate in 401(k) plans can pick the investments they want to make and the amount they want to contribute. After then, investments are made on autopilot each pay period. Employees may notice a greater or lesser amount of securities added to their accounts depending on the markets.
Using dollar-cost averaging is not restricted to 401(k) plans. Investors can use it, for example, to regularly acquire mutual or index funds, whether in a taxable brokerage account or another tax-advantaged account like a conventional IRA.
Consider a person who makes a $100 monthly investment in a business whose shares trade between $10 and $20. The investor will purchase ten shares at a price of $10 per share in the first month. The investor only purchases five shares the following month because each share costs $20. The investor purchases eight shares when a share is worth $12.50 the next month. The investor owns 23 shares after three months, of which nearly half were bought for $10.
Some investors think they may increase their return on investment and lower their risk by managing both the number of shares bought at low costs as well as the number of shares bought at higher prices.
One of the finest trading methods for new investors wanting to trade ETFs is dollar-cost averaging. A lot of dividend reinvestment plans also permit investors to dollar-cost average their investments by making consistent purchases.
Calculating dollar-cost averaging
Under dollar-cost averaging, it is not necessary to know the value of each share at the moment the investor bought it to determine the average cost of a share. You just need to be aware of the investor's total outlay of cash and the total quantity of shares acquired.
The following formula is used to get the average cost:
Amount invested / Number of shares purchased = Average cost per share
For instance, if an investor purchased 12 shares of a mutual fund for $1,000 each, the total investment would be $12,000. The average cost per share if the investor invested $12,000 and bought 500 shares total would be: $12,000 / 500 = $24.
Dollar-cost averaging examples (vs. lump purchases)
You need to contrast dollar-cost averaging with other viable buying methods, such as buying all of your shares at once, in order to see how it may help you. Here are a few examples of how dollar-cost averaging operates.
Scenario 1: Lump-sum purchase
Let's first examine the results of a $10,000 lump-sum purchase of 200 shares of ABCD stock at $50. Assume that when you want to sell, the stock reaches the following prices. The gross profit or loss on each deal is displayed in the column on the right. to sell. The column on the right shows the gross profit or loss on each trade.
| Sell prices | Profit or loss |
| $40 | -$2,000 |
| $60 | $2,000 |
| $80 | $6,000 |
This is the standard case. Let's now evaluate it in relation to others to understand how dollar-cost averaging functions.
Scenario 2: A declining market
Dollar-cost averaging excels in this situation. Assume that over the course of a year, $10,000 is distributed equally among four transactions with values of $50, $40, $30, and $25. These four $2,500 transactions, which represent a significant increase over the lump-sum purchase, will buy 295.8 shares. Examining the profit at the identical sell prices once more.
| Sell prices | Profit or loss |
| $40 | -$1,832 |
| $60 | $7,748 |
| $80 | $13,664 |
By using dollar-cost averaging, you really have a gain overall at the ABCD stock price of $40 per share, which is lower than when you first started purchasing the stock. As a result of owning more shares than you would have with a one-time payment, your investment appreciates faster as the stock price rises, resulting in a total profit at an $80 sale price that is more than quadrupled.
Scenario 3: In a market that is flat
The performance of dollar-cost averaging in a market with some ups and downs but primarily sideways is seen below. Assume that over the course of a year, $10,000 is distributed equally among four transactions at values of $50, $40, $60, and $55. These four transactions will total 199.6 shares, which is essentially the same as a single lump-sum purchase. In this case, you are not significantly better or worse off and the reward profile resembles the first scenario almost exactly.
This situation appears to be the same as a lump-sum buy, but it isn't because you've eliminated the danger of market timing errors at a low cost. Markets and stocks can frequently move for extended periods in a sideways fashion (up and down, but finishing where they started). You'll never be able to predict the market's direction accurately, though.
By dollar-cost averaging in this case, the investor takes advantage of reduced prices when they are offered, even if it results in higher costs down the road. Dollar-cost averaging would have permitted a larger profit if the stock had drifted much lower rather than higher. The key to generating stronger long-term profits is to buy the dips.
Scenario 4: A growing market
Let's imagine that the same $10,000 is divided into four payments at costs of $50, $65, $70, and $80 in this last scenario. 155.4 shares would be yours after these acquisitions. The payment profile is shown below.
| Sell prices | Profit or loss |
| $40 | -$3,782 |
| $60 | -$676 |
| $80 | $2,432 |
The only situation in which dollar-cost averaging seems unreliable, at least initially, is this one. In comparison to a lump-sum purchase, dollar-cost averaging prevents you from maximizing your gains as the stock rises and then keeps rising.
However, unless you're looking to make a quick buck, this is not a situation that frequently occurs in real life. Stocks fluctuate a lot. Even the best long-term investments occasionally decline in value, so you could start dollar-cost averaging at these new, lower prices and profit from that decline. Don't be afraid to spread out your purchases if you're investing for the long term, even if it means paying more at some periods in the future.
Dollar-cost averaging benefits
Dollar-cost averaging has the advantage of removing emotion from the investment process. Even if you purchase dependable, secure stocks and bonds, investing might still be dangerous. You run the risk of losing all or a portion of your investment. An investor may be hesitant to make significant investments out of fear of those possible losses.
Choosing a dollar-cost average will help ease this anxiety because you won't have to make a timing decision regarding your investments. You stick to a predetermined schedule instead. It makes investing easier and requires discipline because you may set up a plan to invest money automatically each month and then completely forget about it.
Dollar-cost averaging also lessens the desire to time the market and make investments when you believe a stock or bond is trading for a bargain. Although market timing can boost your overall returns, it is exceedingly challenging to do well, and the majority of investors who attempt to outperform the market typically fail to do so.
For those who don't have a lot of money set away for investments, dollar-cost averaging is also a successful method. They can begin with modest sums, deduct them from their pay, and add to them frequently.
There are several circumstances in which a one-time purchase is preferable to dollar-cost averaging. However, in general, dollar-cost averaging offers three main advantages that might lead to higher profits. It can assist you in:
- Avoid trading erratically.
- Put emotion aside while investing.
- Think longer-term.
Dollar-cost averaging protects investors against their psychological biases, in other words. Investors are prone to make irrational trading decisions as the market sways because they oscillate between fear and greed.
However, if you're dollar-cost averaging, you'll also be purchased at a good price and perhaps positioning yourself for long-term gains when people are selling out of panic. Dollar-cost averaging might help you see that a stock market crash or bear market might really be a fantastic long-term investment opportunity rather than a threat because the market tends to rise over time.
Who uses dollar-cost averaging?
Any investor who wants to benefit from the advantages of the dollar-cost averaging investment strategy, including a potential lower average cost, automatic investing over time, and a strategy that relieves them of the stress of having to make purchase decisions quickly when the market is volatile, is welcome to use it.
Beginning investors who lack the knowledge or experience to determine the best times to buy may find dollar-cost averaging to be extremely helpful.
For long-term investors who are committed to making regular investments but lack the time or desire to follow the market and time their orders, it can also be a solid strategy.
However, not everyone should use dollar-cost averaging. It may not be suitable for investors at times when prices are steadily moving in one direction or the other. When deciding whether to employ dollar-cost averaging, be sure to take into account both the broader market and your expectations for the investment.
Special things to consider
It's vital to remember that when an investment's price varies up and down, dollar-cost averaging is an effective way to purchase it over a certain period of time. Those that use dollar-cost averaging wind up purchasing fewer shares if the price continues to rise. They might keep buying when they ought to be staying away from the market if it keeps declining.
Therefore, the technique is unable to shield investors from the risk of falling market prices. The method makes the same long-term investment assumption that prices will eventually increase, notwithstanding occasional drops.
Using this method to purchase a single share of stock without first learning about the firm could also be risky. This is so that an investor won't quit buying shares or selling their investment when they normally would.
When utilized to purchase index funds rather than individual equities, the method is significantly less risky for less experienced investors.
Dollar-cost-averaging investors typically reduce their cost basis in an investment over time. The lower cost basis will result in smaller losses on investments that experience price declines and larger gains on ones that experience price increases.
Where do you start?
You can make dollar-cost averaging as simple as investing in an IRA with a little upfront work. It's not difficult to set up a plan with the majority of brokerages, but you will need to decide which stock — or, preferably, which well-diversified exchange-traded fund — you'll buy.
Then, you can provide your brokerage instructions to create a strategy for an automatic purchase schedule. You can set up your own purchases on a regular schedule, such as the first Monday of the month, even if your brokerage account doesn't offer an automatic trading plan.
The key thing is to keep investing consistently, regardless of stock prices and market jitters. You can pause the investments if necessary. When it comes to dollar-cost averaging, keep in mind that markets in decline represent an opportunity.
Here's one last tip to give dollar-cost averaging a little more energy: It's common to request a brokerage to automatically reinvest income from many stocks and funds. This enables you to keep purchasing the stock and gradually multiply your gains.
FAQ
Is dollar-cost averaging a good idea?
By investing the same sum on a monthly basis, dollar-cost averaging aims to reduce your average purchase price. When prices decrease or increase, you will already be in the market. For instance, you won't need to try to time dips because you'll be exposed to them as they occur. You will end up purchasing more shares when the price is lower by consistently investing a certain amount than when the price is higher.
Why do investors use dollar-cost averaging?
Dollar-cost averaging's main benefit is that it lessens the detrimental effects of investor psychology and market timing on a portfolio. By committing to a dollar-cost averaging strategy, investors reduce their risk of making unwise choices out of greed or fear, such as buying more while prices are rising or dumping all of their holdings in a panic when prices are falling. Dollar-cost averaging, on the other hand, forces investors to concentrate on making a specific amount of contributions every period while ignoring the price of the target security.
How often should you invest in dollar-cost averaging?
How frequently you utilize the technique will depend on your investment horizon, market forecast, and level of investing experience. You might give it a try if you believe that the market is in turmoil but will eventually recover. It wouldn't be a wise technique to utilize if a protracted bear market was at play. If you want to utilize it for long-term investing and are unsure of how often to buy, think about allocating a portion of each paycheck to the necessary purchases.
When is the right time to invest using dollar-cost averaging?
Dollar-cost averaging may be appropriate in two situations.
One is when you wish to make regular investments but don't have a lot of money to invest. To have your company automatically deduct funds from each paycheck to make recurring purchases in your 401(k) account, you can set up an automated investing plan.
When you have a low level of risk tolerance, you should also apply dollar-cost averaging. Because there is a chance that their investment could lose value quickly, some investors are hesitant to invest a large sum of money all at once. You can lessen the impact of any one price decline on your losses by making regular, smaller purchases.
The drawback is that if the stock you're buying increases in value, you risk missing out on possible gains because you didn't invest all of your funds at once.
How long should you do dollar-cost averaging for?
You should be able to leave your money in an investment for at least three to five years with any form of stock or fund. Try to give the investment some time to grow and overcome any temporary price losses because stocks can change greatly over short periods of time.