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Dollar Cost Averaging: What It Is and How to Use It
Dollar-Cost Averaging: What It Is and How to Use ItThere are two types of investing behaviors to consider. Let’s demonstrate this by referencing how people may enter a pool.
One group is eager to get in, no matter how warm or how cold the temperature is. This group goes all in, taking the risk. Another group sits back, observes, and slowly edges themselves into the water. They take the time to adapt before progressing.
When it comes to investing, which group do you fall into? The latter is equivalent to dollar-cost averaging, which we will go into more depth on in this article.
What Is Dollar-Cost Averaging?Using dollar-cost averaging, or DCA, is easier than you think. The process refers to the contribution of monies to an investment fund in equal portions, or at regular intervals. Investments may include mutual funds, stocks, or exchange-traded funds (ETFs).
For example, if an investor spends $100 to purchase stock shares today, they will continue to purchase them on an ongoing basis. This could be once a month, once a quarter, or once a year. The timeframe is up to the investor.
Should the price of an investment trend upwards or downwards in the financial market, it doesn’t matter. An investor continues to commit and contribute at the preplanned intervals, reducing market risk.
You may be familiar with dollar-cost averaging already if you contribute to a workplace retirement plan, such as a 401(k). A predetermined contribution amount is set and automatically drafted from your paystub, growing the balance in your investment fund.
Other Names for Dollar-Cost AveragingDollar-cost averaging goes by numerous names which include:
- Unit Cost Averaging
- Incremental Averaging
- Cost Average Effect
- Pound Cost Averaging (in the U.K.)
How Does Dollar-Cost Averaging Work?Now that you are more familiar with what dollar-cost averaging is, let’s break down how it works.
There are some prerequisites to determine before implementing this strategy:
- How much you are planning to invest? This is the total dollar amount.
- How often the contributions are to be made? This is either daily, weekly, monthly, or annually. You set the frequency.
- Are there a specific number of periods you want to distribute your investment over? Or will you implement this strategy indefinitely?
- How much of the total identified to invest are you comfortably able to budget and afford?
- Are you committed and able to stick to the plan?
You decide that you want to invest $100 per month, for a total of three months.
- Month 1: The stock share you have your eyes on is $25 per share the first month, starting you off with four shares.
- Month 2: The stock value increases and is now $50 per share. You continue to invest $100, adding two shares to your portfolio.
- Month 3: The stock value decreases and is now $5 per share. Your $100 contribution adds 20 shares to your portfolio
To determine this, take the total amount of your contribution and divide it by the total number of shares acquired:
$300 / 26 shares = $11.54
This means that the average price per share you paid is $11.54. You’ll gain a profit for any shares sold after Month 3 assuming the value of the stock is greater than $11.54.
Is One Day Better Than Another When Using Dollar-Cost Averaging?Some investors believe that there is specific day money should be vested. This is dependent on payroll cycles, and mutual fund flows. Is it true? The best answer is that it hasn’t been proven.
If there was a science, then there wouldn’t be a multitude of strategies to choose from. Everyone would know when the market is at its lowest or highest and take action.
The key with dollar-cost averaging is that you choose a date in time and do not deviate from the tracks, no matter what happens in the market.
What Does Dollar-Cost Averaging Means for Investors?Some may question this, is that good or bad? Let’s put it this way when an investor purchases a stock while it’s performing at its highest, they are purchasing fewer shares than when it is performing at its lowest. However, the same dollar amount is spent at the time of purchase.
That is where the dollar-cost average strategy comes into play. An investor invests over a period of time. The average cost per share, when measured, may be lower than the average market price of that share (even though it may not appear this way to the investor). This is a win!
Dollar-Cost Averaging Ends ProcrastinationProcrastination is experienced by many, especially when it comes to investing. How many times have you said you’ll “wait until tomorrow” to finish a task?
Through dollar-cost averaging, funds are immediately transferred to an investment account. Out of sight, out of mind is a great concept, and dollar-cost averaging uses it to help people invest towards their future.
Build good investment habits through dollar-cost averaging. This strategy adds discipline to your regular contributions and keeps you focused on fulfilling a set plan.
Dollar-Cost Averaging Removes the Emotional AspectInvesting requires time, commitment, and a strong handle on an investor’s emotions. It’s human nature to feel burned, and to get upset when you view your portfolio balance and it’s close to your benchmark for it to rapidly decline overnight.
This is where investors need to ground themselves because generally their wealth can be rebuilt with both knowledge and patience.
Using dollar-cost averaging removes the emotional component from the game. How? Because the decision-making door is closed. You’ve already decided and are committing to an amount to contribute as a recurring transaction.
Dollar-Cost Averaging Does Not Require a LumpsumIt is not often that an investor has a lump sum to invest in one sitting. This strategy does have its benefits, but many prefer to invest over time.
Lump-sum investing has a higher risk than that of dollar-cost averaging. It’s all or nothing. Could it provide the highest return on investment? Maybe. But it could also leave you with less than you started in a short amount of time.
Dollar-cost averaging, on the other hand, still has a level of risk associated with it but the threshold is smaller since you hold more control over your investments. You may even come out with a lower cost per share than if purchased at lumpsum.
A scenario of Lumpsum Investing
Let’s assume the same investment amount of $300 in this scenario as we did with dollar-cost averaging and demonstrate it in lumpsum investing.
During the first month, the full amount of $300 is vested. At $25 per share, you acquire 12 shares. In this example, you are already starting off with owning fewer shares at a higher cost than with the dollar-cost averaging strategy.
Lumpsum investing is beneficial to investors who have a large sum of cash on hand to invest and are looking for a high return in the short term.
Dollar-Cost Averaging Does Not Focus on Market TimingMarket timing relies on data to predict the future, moving money in and out of the financial market based on those predictions. This undoubtedly leads to regret or procrastination, which is what investors should want to avoid.
Is there ever a “right time” to invest your money in the stock market? Sure, there are historical data and trends available for investors to analyze but waiting for the “right time” could essentially cost more money than it’s worth.
Dollar-cost averaging isn’t worried about whether the perfect time to invest is then or now. Instead, its purpose is to ensure that the account builds value over time with consistent deposits. The market doesn’t stand still, it is constantly fluctuating.
What Are the Drawbacks to Dollar-Cost Averaging?Dollar-cost averaging may not be the best strategy for all investors to use. Here’s why:
- The level of risk is lower, but higher returns may be forfeited
- Brokerage fees add up
This strategy is best for investors who are focused on holding investments long-term. It requires persistence and sticking to a plan.
Think about your investment goals and choose a strategy that best aligns. If you are more concerned about losing money than you are about high returns, dollar-cost averaging may be a good fit for you.
Who Should Add Dollar-Cost Averaging To Their Investment Strategy?You may benefit from dollar-cost averaging if:
- You are a novice and are working with a small amount to invest
- Are not interested in devoting time to conducting the market research required for market timing
- Contributions are already being made, or you are interested in making, to an IRA or a 401(k)
- You know you won’t be able to handle the emotions when the market declines
The Bottom LineEach investor is unique in their way. Each has an investment goal to attain, and their preferred strategy to follow. Investing sooner, rather than later is one of many important factors to a successful financial future.
Dollar-cost averaging provides investors with a realistic approach to the market. Since investing is not a mathematical equation with a finite answer, prices vary; they are subject to change at any time.
Don’t fear investing or have any remorse should your portfolio drop in value. Use dollar-cost averaging to avoid short-term volatility, and to keep yourself disciplined in contributing recurring dollars to your financial future.
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