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What is Dollar-Cost Averaging (DCA)?
Dollar-cost averaging is an investment strategy that requires dividing up a total investment amount and allocates fixed investments across a specific period of time.
Key Takeaways
- Dollar-cost averaging is an investing strategy to invest a fixed amount over certain time intervals.
- DCA can potentially reduce volatility risks when investing.
- A DCA strategy may result in a lower average cost per share.
- DCA can be a good strategy for investors who want to take the emotion out of investing.
- If an investment is consistently appreciating in price, a DCA strategy may result in fewer shares for the investor, and a higher average cost per share.
How Dollar-Cost Averaging Works
Dollar-cost averaging requires an investor to invest a fixed dollar amount at regular time intervals (weekly, monthly, quarterly, etc.). By setting fixed, timed investments, investors disregard the price of an asset and always invest the same amount.
Over time, if the price of the asset decreases, the investor can buy more shares with the same fixed investment. This can potentially result in a lower average cost per share, which is why this investment strategy is called “dollar-cost averaging”.
Who Should Use Dollar Cost Averaging?
If you have a potential investment but are unsure whether it’s currently priced too high or too low, DCA might be for you. Because dollar-cost averaging requires investing smaller amounts over longer periods of time, it can help minimize the impact of volatility on an investment.
Doing this also helps take some of the emotion out of investing, and sets a fixed investment schedule instead of requiring you to decide when is the best time or best price to invest in a certain asset.
How to Invest Using Dollar-Cost Averaging?
Here is how a typical dollar-cost averaging strategy might look:
- Select a target asset for your investment, such as a stock, bond, mutual fund, or exchange-traded fund (ETF).
- Choose the total amount you’d like to invest and over what time horizon.
- Decide your investment schedule (i.e., every week, month, quarter).
- Divide your total investment amount by your investment schedule and horizon.
- Use this number to invest in your regular intervals.
- Automate your dollar-cost averaging (if possible).
- Monitor and rebalance your investment (if necessary).
Example of Dollar-Cost Averaging
Imagine you want to invest $3,000 in a stock that’s currently priced at $30. However, you aren’t sure whether the stock will rise or fall in the short term. So, you decide to use a dollar-cost averaging strategy to help reduce your volatility risk.
For your DCA strategy, you choose an investing interval of once per month over the next year. Therefore, you choose to invest $250 per month ($3,000/12 months) regardless of the stock price at the time.
Keep in mind the stock price fluctuates each month. In a typical scenario, your investment might look something like this:
| Month | Stock price | Investment amount | Shares purchased |
|---|---|---|---|
| 1 | $30 | $250 | 8.33 |
| 2 | $25 | $250 | 10.00 |
| 3 | $22 | $250 | 11.36 |
| 4 | $20 | $250 | 12.50 |
| 5 | $18 | $250 | 13.89 |
| 6 | $15 | $250 | 16.67 |
| 7 | $17 | $250 | 14.71 |
| 8 | $19 | $250 | 13.16 |
| 9 | $21 | $250 | 11.90 |
| 10 | $22 | $250 | 11.36 |
| 11 | $24 | $250 | 10.42 |
| 12 | $26 | $250 | 9.62 |
| Total Shares | 143.92 | ||
Using this DCA strategy, you’d purchase 143.92 shares at the end of one year. However, if you had used a lump sum strategy and invested all of your money into the stock at the beginning of the year, you’d only have 100 shares.
Therefore, using a DCA strategy would result in 43.92 extra shares for the same investment.
Dollar-Cost Averaging Pros and Cons
- Can help manage volatility risk
- Can be utilized by small investors
- Eliminates emotional investing
- Averages out purchase price for an asset
- Potential lower returns in a rising market
- Transaction costs can eat away at profits
- Requires discipline over a long period of time
- Can miss out on potential gains
The Bottom Line
Dollar-cost averaging has been a strategy utilized by investors for decades. If you follow the DCA definition, you’ll likely take the emotions out of your investing strategy, which can help you make more unbiased investing decisions.
However, keep in mind that in an upward-trending market or asset class, this could result in lower profits than investing in a lump sum.
