As you dive deeper into investing, you will likely run across the term dollar-cost averaging. The concept of DCA investing is used to replace the strategy of lump sum investments over time and maybe one you'd like to try. In this article, I'll explain exactly what it is and after that, we’ll explore dollar-cost averaging benefits.
What is dollar-cost averaging (DCA Investing)?
When you decide to pursue dollar-cost averaging, you’ll commit to a strategy in which you invest your money in equal portions at regular intervals. Basically, instead of trying to time the market with a large lump sum purchase, you will make smaller purchases over time.
For instance, with this strategy, you’ll buy more investments when the market price is low and fewer investments when the market price is high. This is in direct contrast to a lump sum investment approach in which you buy a large amount of stock either when the price is low or high.
In other words, DCA investing creates an average of low and high purchase prices, which provides an opportunity to spread out the risk of investing. Dollar-cost averaging can be especially useful in a volatile marketplace.
Example of dollar-cost averaging
Here’s take a look at an example of dollar-cost averaging to create a better understanding of this investment strategy.
Let’s say that you have a 401(k) through which you regularly invest each month with a portion of your paycheck for instance. The funds taken from your paycheck will be invested every pay period. As a result, you’ll find that sometimes your investments are bought at a low price, and other times you’ll hit the higher prices. However, over time, the average of your buy-in costs will be averaged, likely leading to a more favorable result.
Below is a hypothetical example of lump sum vs dollar-cost investing over a period of 4 months.
Lump-sum purchase: $10,000
|Month||Share price||Number of shares purchased||Amount spent|
|1 (Lump sum)||$50||200||$10,000|
|Total shares purchased||200||$10,000|
DCA Investing: $2,500 per week
|Month||Share price||Number of shares purchased||Amount spent|
|Total shares purchased||213||$10,000|
|Average share price||$47.5|
In this example, the lump sum investment only purchased 200 stocks at $50 each. However, by leveraging DCA, the share price average was lower at $47.50, and over the four months purchased 213 stocks. Again this is simply an example to illustrate.
Of course, there is always the risk that you would have done better with a lump-sum purchase. But generally, dollar-cost averaging tends to spread out the risk.
Dollar-cost averaging benefits
Now that you know a little bit more about dollar-cost averaging let’s dive into the dollar-cost averaging benefits. You might be surprised by how much this strategy can improve your investment portfolio.
One of the most important dollar-cost averaging benefits is the potential to lower your risk over time. Through dollar-cost averaging, you’ll build out your portfolio at a regular pace. For instance, instead of jumping into time the market, you’ll spread out your investment capital over a longer period of time.
As a result, you can minimize losses and possibly tap into higher returns. In addition, you’ll enjoy the benefits of reduced risk in your portfolio.
Is lower cost
Based on the above example, dollar-cost averaging gives you more bang for your buck. And throughout the course of your investment strategy, you’ll potentially be able to buy more shares at a lower price. If you had made a lump sum investment at a high point in the market, you would own fewer shares.
Enables habitual saving
However, in order for you to really capitalize on the benefits of dollar-cost averaging, you’ll need to maintain a habitual savings plan. And, you will need to regularly add money to your investment account. Hopefully, these regular contributions will keep you on track towards your financial goals.
Avoids market timing
Many professionals claim that they can beat the market by timing their purchases to buy low and sell high. But the vast majority of investors miss the mark and cannot keep up with the returns provided by the market as a whole.
Dollar-cost averaging prevents you from timing the market. Instead, you’ll make regular investments over time. And likely outperform the market timers.
Handles the emotional component of investing
As you build your investment portfolio, it can be difficult to part with large sums of money. After all, investing comes with risk. In addition, it can be challenging to put your hard-earned dollars at risk.
Luckily, dollar-cost averaging can help. The strategy requires you to part with smaller chunks of money. On an emotional level, it can be easier to invest $2,000 at a time instead of $10,000 at once.
Everyone has to manage the emotions surrounding investing. It can be tricky without a clear understanding of your risk tolerance. Not sure where you stand? Take our risk tolerance quiz.
Dollar-cost averaging drawbacks
As with every financial choice, there are some drawbacks to consider. And here’s what you should consider before diving into DCA investing.
An obvious problem with dollar-cost averaging is that you’ll have to make more transactions. And more importantly, the transaction costs can add up quickly. You can minimize this problem by working with a brokerage firm that provides low-cost opportunities to invest.
Tricky to realign asset allocation
As you invest, you’ll need to keep your asset allocation in order. Essentially, that means that you’ll need to make sure that your investment continually reflects your goals and risk tolerance.
It can be tricky to keep things in alignment with dollar-cost averaging. However, as a careful investor, you can realign on a regular basis to keep your portfolio on the right path.
Need a long-term commitment to investing
Dollar-cost averaging will require you to add money to your investment portfolio continually. The constant need to make regular contributions can be difficult for some to keep up with. In other words, as an investor, make sure that you are willing to make a long-term commitment before diving in.
Dollar-cost averaging calculators to try out
Want to see how dollar-cost averaging could affect your investment plans? Check out these free dollar-cost averaging calculators to see the potential.
Dollar-cost averaging calculator from Merrill Lynch
This is a simple dollar-cost averaging calculator from Merrill Lynch. It's also easy to use and highlights the benefits of regular investing with this strategy.
Dollar-cost averaging calculator from Buy Upside
This calculator from Buy Upside is a slightly more complex version of a DCA calculator. It allows you to calculate dollar-cost averaging based on investments in individual stocks. And this can be useful for someone who is creating a broad portfolio that includes individual stocks.
Bitcoin dollar-cost averaging calculator
Bitcoin dollar-cost averaging calculator is focused on crpytocurrency investors. It's great for calculating potential dollar-cost averaging returns if you want to invest in Bitcoin for instance. (Learn what you need to know about investing in cryptocurrency.)
Should you use dollar-cost averaging as an investment strategy?
Dollar-cost averaging is a smart move for many investors especially those investing with small amounts. However, you should weigh the pros and cons of dollar-cost averaging before you move forward.
Need more help getting started? I highly recommend taking advantage of our free course that dives into the ins and outs of investing. As you create a plan for your investments, you can decide if DCA investing fits into the picture.
The bottom line
In conclusion, dollar-cost averaging can be a useful strategy for many investors. With the ability to potentially lower your risk and increase your returns, dollar-cost averaging can be a win-win for most. Above all, make sure that you are willing to commit to a long-term investment strategy before committing to DCA investing.