Investment advisors frequently suggest dollar-cost averaging in their articles and publications, but what does it mean? Why do many advisors believe it is the best strategy?
What Is Dollar-Cost Averaging (DCA)?
Dollar-cost average is an investment strategy where an individual invests a fixed amount at regular intervals into the same stocks, mutual funds, or ETFs (exchange-traded funds). No matter what the financial markets are doing, the dollar amount never varies.
How Does Dollar Cost Averaging Work?
At times when the market price per share is high, the amount invested buys fewer shares of the investment. Conversely, at times when the market prices fall, the investor is able to purchase more shares.
The Dollar-Cost Averaging Formula
The dollar-cost averaging formula is as follows:
A Practical Dollar-Cost Averaging Example
The formula may look complex, but once numbers are used in an actual example, it becomes much clearer.
Jeff wishes to invest in a mutual fund. He selects Fund A, a mutual fund consisting of a number of blue chip stocks, and decides to invest $3,000 using dollar-cost averaging. He will invest $1,000 each month for three months.
In the first month, Fund A’s share price is $25 so Jeff is able to buy 40 shares with his $1,000. The next month, Fund A’s shares are $20 each, so he buys 50 shares ($1,000). The third month, the fund’s share price remains at $20 per share, so he buys 50 more shares ($1,000).
This is what the dollar-cost averaging formula looks like:
If Jeff had invested the entire $3,000 in month 1, he would have owned 120 shares. Using dollar-cost averaging, his $3,000 purchased 140 shares.
Dollar-cost averaging results in lower average costs when the stock price is in a downward trajectory (as in the example). If the stock price is in an upward trajectory, the investor could end up with a higher average cost.
Dollar-Cost Averaging vs. Lump Sum
Dollar-cost averaging uses time to buffer the effects of market volatility. Lump sum investing places the entire amount to be invested into the market all at once.
If you expect – with reasonable certainty – that an investment will increase in value over time, then lump sum investing makes sense. If the investment is likely to experience significant price fluctuations, however, then dollar-cost averaging may be a better choice.
Does Dollar-Cost Averaging Work?
Eliminates the Need for Market Timing
The majority of investors cannot adequately time the financial market (and may lose money trying to do so). Dollar-cost averaging eliminates the need for market timing, or trying to “buy low/sell high.”
Helps Investors Contribute Regularly
It's an attractive option for investors who want to contribute to their investment portfolios on a regular basis. Most people find it easier to invest small amounts at regular intervals than to save up a large amount to invest as a lump sum.
If you put all of your money into the market as a lump sum, and the market takes a sudden downturn, you may panic and sell at a loss. However, if you’re using dollar-cost averaging – and you continue to invest during the downturn – you’ll be adding more shares at a lower price. When the market recovers, you’ll end up in a better position with more shares in your portfolio. This may take some of the stress out of investing.
Ask an Expert:
Is Dollar Cost Averaging a Good Investment Strategy?
Dollar-cost averaging is a good investment strategy when investors:
Choose volatile investments such as stocks, mutual funds, and ETFs
Experience low risk tolerance
Have a long-term investment horizon
Volatile investments (such as stocks) are good candidates for dollar-cost averaging. Investors are able to take advantage of lower share prices to purchase more shares without having to time the market. Bonds and money market funds tend to be much more stable and are better suited to lump-sum investing
When Does Dollar-Cost Averaging Work Best?
It works best when discipline is needed to enforce investing and time is on the investor’s side. Few people have the financial discipline to save for a lump sum investment. Dollar-cost averaging enables investors to buy more shares (over time) than they could with a single lump sum investment.
Dollar-cost averaging also takes a lot of fear and uncertainty out of the short-term markets and volatile investments. It is not, however, a guarantee for making money. No single strategy fits every person and situation, but understanding how dollar-cost averaging compares to lump sum investing can help an investor sift through their choices and make better decisions for their personal circumstances.
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