What is Dollar-Cost Averaging (DCA)?

One of the scariest aspects of investing is that no one ever really knows what will happen next in markets. One popular strategy for lowering risk and making investing a bit more easier to understand but not popular amongst speculators is called dollar-cost averaging (DCA). 

It consists of reinvesting the same amount regularly, without changing it as a function of market conditions. By investing over steady dips in time, DCA can also help dampen the effect of market volatility and reduce the average price of investments. This article discusses dollar cost average, its benefits, challenges and the right way to do it.

Understanding Dollar-Cost Averaging

Dollar-cost averaging (DCA) is an investment strategy in which an investor divides the total amount allocated for a target asset's recurring purchases. The aim is to reduce the impact of volatility on the overall purchase. 

By purchasing shares at regular intervals and in equal amounts, investors can avoid the risks associated with attempting to time the market.

How Dollar-Cost Averaging Works

Dollar-cost averaging is by principle very simple. This style of investment refers to someone deciding to avoid a lump-sum investment and rather regularly invest smaller denominations with regards to the creation of wealth over time. 

For example, instead of putting $12,000 often a stock at once, an DCA investor would invest $1,000 a month for 12 months.

Example Scenario

Let's say you decide to invest $1,000 each month in a single stock. This is how the stock price moves in the next five months:

• Month 1: $10 per share
• Month 2: $12 per share
• Month 3: $8 per share
• Month 4: $11 per share
• Month 5: $9 per share

Using DCA, you would buy:

• Month 1: 100 shares
• Month 2: 83.33 shares
• Month 3: 125 shares
• Month 4: 90.91 shares
• Month 5: 111.11 shares

In total, you would have purchased 510.35 shares. The average price per share would be lower compared to making a lump sum investment at the highest price point.

Benefits of Dollar-Cost Averaging

1. Mitigates Market Volatility

Dollar-cost averaging is one of the most effective ways to offset the negative emotions associated with market volatility. Additionally, you are able to avoid making emotional mistakes tied to short-term market movements when you invest on a recurring direct deposit basis.

2. Simplifies Investment Decisions

By making regular investments over time, the market timer finally has an investment methodology to implement in a disciplined fashion. No need to second guess if it is a good time to invest because you are investing on a regular basis over the long term.

3. Reduces Emotional Investing

The average person does not want to invest a ton of money in the market all at once, especially with our markets recently being extremely volatile. Dollar-cost averaging lessens the emotional burden by breaking investments into multiple, more digestible installments.

4. Lowers the Average Cost of Investments

The idea is that doing it over time, will give you a lower average cost in your position. In other words, you buy more shares when prices are low and buy fewer shares when prices are high, allowing you to end up with a nicer average cost.

Drawbacks of Dollar-Cost Averaging

1. Opportunity Cost

Another disadvantage of dollar-cost averaging is missing out on opportunity. If the market always goes up, then investing the lump sum at time 1 is better than dollar cost averaging over time.

2. Slow Capital Deployment

Dollar cost averaging can slow down capital deployment. In a good market, sleeping on cash can mean missing out on returns.

3. Requires Discipline

That is true because while DCA makes the investing process easy, it means having to trust in it - even during market lows. Investors should invest in a disciplined manner irrespective of the market tendency.

Implementing Dollar-Cost Averaging

1. Define Your Investment Amount and Frequency

You have to decide how much money you want to invest and how often you would like to do so. It could be weekly, monthly or quarterly. The key is consistency.

2. Choose Your Investments

Choose your assets to invest-stocks, mutual funds, ETFs. You should pick investments that you are able to tolerate with your financial goals.

3. Automate Your Investments

Automate the investments to make sure you keep up with them. There are automatic investment plans offered through many brokerage accounts or financial institutions that let you invest a set amount at regular intervals.

4. Monitor and Adjust

Lastly, with dollar-cost averaging mitigating the requirement to keep an eye on your portfolio all the time, you required to check in with your financial plan once in a while. Make sure your investments are generating the desired returns and take corrective action to remedy it if they are not.

Dollar-Cost Averaging vs. Lump Sum Investing

The decision to dollar-cost average or employ a lump sum investment strategy can be driven by your financial circumstances and the current market landscape relative to your investing timeline.

Lump Sum Investing

Lump sum investing involves placing a large amount of money [i.e. your retirement savings] into an investment at once. This strategy can be useful if you think the market is going to go up because it allows you to benefit from a rally. But, of course, risks are higher as well, because if the market descends again then your savings can be affected quite a lot.

Dollar-Cost Averaging

Dollar-cost averaging, on the other hand distributes that risk over time. This makes it very useful in volatile markets, since the effect of market fluctuation will be diminished. Nevertheless, in an increasingly escalating market, DCA can potentially lead to lesser returns than that of lump sum investing.

Psychological Benefits of Dollar-Cost Averaging

1. Reduces Decision Paralysis

The dreaded decision paralysis of when to deploy an enormous pile. Dollar-cost averaging obliterates that burden, as you can put your investments on autopilot, saving you time and stress of making those choicest about investment opportunities.

2. Builds Consistent Habits

Dollar-cost averaging ingrains the discipline of steady investing by advocating for periodic deposits and systematic saving. This regularity can result in a large long-term development.

3. Encourages Long-Term Perspective

Dollar-cost averaging emphasizes that over time, you will always come out on the right side and thus can promote long-term thinking about investing. This keeps the investments from being subject to short term investment considerations

Conclusion

Dollar-cost averaging is a great tool to help reduce the risk of an investment, keep you from having to make decisions and train yourself to invest consistently over time. Putting into the practice of investing the same pre-set number of dollars at regular intervals, cost-of-averaging allows investors to smooth out market fluctuations and perhaps bring down the average price they pay for their investments. 

DCA, while not always resulting in the highest returns relative to lump sum investing—especially in rising markets—provides a level-headed strategy that can be advantageous for new investors or those who seek help excluding some of the behavioral stress of market timing. Whether for your retirement or long-term portfolio or to help build wealth over time, dollar-cost averaging can be a development strategy worthy of your consideration.