What Is Dollar-Cost Averaging? All You Need To Know About This Investing Strategy
In a world of financial uncertainty, investors often seek strategies to help mitigate risk while still offering the potential for growth. One such strategy is dollar-cost averaging (DCA), which involves investing a fixed sum of cash into assets at fixed intervals.
In today’s article, we will further explore dollar-cost averaging, explain what it is and how it works, and go through some pros and cons associated with this investment technique.
What Is Dollar-Cost Averaging and How Does It Work?
Dollar-cost averaging is an investing strategy whereby an investor buys a fixed amount of a particular asset at fixed intervals. The goal of dollar-cost averaging is to reduce the effects that sporadic changes, or “market noise,” can have on the overall investment. By buying securities at regular intervals, the investor reduces the chances of buying at either the top or bottom of the market.
Over time, this strategy can help lower the average price of the security, as well as reduce the risk associated with timing the market. And while there is no guarantee that dollar-cost averaging will always lead to profitable investments, it can be a helpful tool for those looking to build a long-term portfolio.
Dollar-cost averaging can be employed when investing in mutual funds, stocks, bonds, and exchange-traded funds (ETFs). You can use it when buying investments through a broker or when investing in 401(k) or other retirement accounts.
If you’re considering employing the dollar-cost averaging strategy, it’s important to be aware of the potential gains and risks associated with this type of investing. Below, we'll take a closer look at both.
Pros and Cons of Dollar-Cost Averaging
As much as it can be beneficial, dollar-cost averaging also has a few drawbacks. Let’s see how this strategy stacks up by taking a look at some of the pros and cons associated with it.
First of all, this strategy takes the emotion out of investing since you are buying securities regardless of whether the market is up or down. This can help you avoid making mistakes based on emotions like fear or greed.
Additionally, it can help reduce your overall costs since you will not be purchasing shares at a single price point, but will rather be buying more shares when prices are low and fewer when prices are high. When done correctly, this can lead to a lower average price per share over time.
In addition, dollar-cost averaging can make investing lucrative and increase your chances of success since you are buying a little bit of something at regular intervals rather than trying to time the market.
However, there are also some drawbacks associated with this strategy. For example, if the security you are investing in goes down in value immediately after you make an investment, you will have to wait until the next interval before you have a chance to buy more and potentially offset your loss.
Also, if the security you are investing in pays dividends, you will miss out on these if you are reinvesting at fixed intervals rather than as they are paid.
As with any investment strategy, it is important to research and understand the potential risks and rewards before deciding whether or not dollar-cost averaging is right for you.
How To Dollar-Cost Average
There are two ways you can go about dollar-cost averaging. You can do it manually or automatically.
If you choose to do it manually, you will need to decide how much money you want to invest and at what intervals. For example, you may decide to invest $500 every month. Once you have decided on these factors, you will need to set up your investment account and make a purchase at the chosen intervals.
If you decide to dollar-cost average automatically, you can set up an investment account that will do it for you. Many brokerages offer this service, and it is often free.
With this method, you simply need to set up an investment budget, and the brokerage will develop a systematic investment plan for you. Your broker will make the investments for you and may even reinvest any dividends.
Who Is Dollar-Cost Averaging For?
Dollar-cost averaging is often recommended for investors new to the stock market or those who wish to start investing but have limited funds. Dollar-cost averaging helps reduce the effects of volatility, providing a steadier way to build your portfolio. Here’s a dollar-cost averaging example to show you how it works.
Let’s say an investor wants to purchase a stock currently trading at $50 per share. Using dollar-cost averaging, the investor would buy 10 shares (for a total investment of $500).
If the price drops to $40 per share, the investor will buy an additional 10 shares (for a total investment of $400). As a result, the investor’s total cost basis would be $900 for 20 shares, or an average cost per share of $45.
If the price later rises to $60 per share, the investor will have an unrealized gain of $200. And if the price continued to rise and reached $100 per share, the investor’s unrealized gain would be $1,000.
When combined with a long-term investment horizon, dollar-cost averaging can help investors overcome market volatility and achieve their financial goals. Also, as dollar-cost averaging can help reduce the effects of market timing, it can be a useful strategy for investors unable to actively monitor the markets.
When To Use Dollar-Cost Averaging
Dollar-cost averaging is most effective when an investor slowly builds a position in a security or securities over months or years. When used in this way, dollar-cost averaging can prevent potential fear-induced errors such as panic selling, as well as eliminate the temptation to try and time the market when buying shares of a stock all at once.
By using dollar-cost averaging, investors know that no matter what happens in the short term, they will be buying more units when prices are down and fewer units when prices are up, which means their average cost per unit will go down over time.
Of course, there are times when markets are clearly moving higher or lower, and investors may want to invest one lump sum rather than spread their investment into several smaller amounts over time (or vice versa).
But for most people, especially novice investors, DCA investing is a better strategy than lump sum investing, ensuring that more of an asset is purchased when prices are low and less when prices are high.
Dollar-cost averaging is a tried-and-true investment strategy that can help investors weather the ups and downs of the stock market. By buying shares over time, investors minimize risk by spreading out their investments instead of doing it all at once.
There are both pros and cons to dollar-cost averaging, but when done correctly, it can be a very effective way to invest your money. If you’re interested in learning more about this investing technique, but are unsure how to make dollar-cost averaging work, or how to do a dollar-cost averaging calculation yourself, be sure to speak with a financial advisor.
How often should you invest with dollar-cost averaging?
There is no set time frame on how often you should invest when using dollar-cost averaging. However, most investors choose to invest regularly (monthly, quarterly, etc.), regardless of the market conditions. You should also consider how much money you have available, as that will dictate how often you can invest.
What are the three benefits of dollar-cost averaging?
- Dollar-cost averaging can help reduce the effects of market volatility.
- It can take some of the emotion out of investing by reducing the need to try and time the market perfectly.
- When combined with a long-term investment horizon, it can be a valuable strategy for achieving your financial goals.
Is dollar-cost averaging a good idea?
Now that we’ve answered “What is dollar-cost averaging?” and explained how dollar-cost averaging works, it’s time to address the question, “Is it a good idea?” The answer is - it depends.
This strategy can be a good idea for risk-averse investors who don’t have the time to monitor the markets continuously. It can also be beneficial for those who are investing for the long term and have a set financial goal in mind.
However, keep in mind that even with this strategy, there are no guarantees, and you could still lose money if the markets turn for the worse.
For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.
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