Dollar-cost averaging (DCA) is an investment approach that lets investors buys assets over a specified period of time, for example months or even years, using a fixed amount of money.
For example, you may purchase $1,000 worth of a particular stock or exchange traded fund (ETF) each month for a year. Doing this allows you to purchase the ETF at different prices instead of buying the shares all at once at what may be an unfavorable price.
As the price of the ETF varies from month to month, you acquire the ETF at an average price per share over the year.
This has the effect of smoothing out the price you pay for the ETF over time. It also allows you to purchase more shares when the price is low, and fewer shares when the price is high since the dollar amount of money invested stays the same each month.
Stash explains dollar-cost averaging (DCA)
DCA is used most often when an investor is concerned about the potential risks of investing a sum of money all at once, which is called Lump Sum Investing (LSI). It’s also a good way for investors to be disciplined about putting money to work in the market and can reduce some of the emotions that often go with investing.
It’s very difficult to know when the stock market may drop. The DCA is a way to reduce the anxiety of putting a large sum of money in the market at the wrong time.
An important feature of DCA is that it requires making a commitment to investing a fixed dollar amount every month for it to be a successful. If an investor does not take advantage of buying more shares when prices are low and fewer shares when prices are high, then the benefits of DCA are largely lost.
Why is dollar-cost averaging important?
DCA can be an effective strategy to help people who are new to investing and may be concerned about putting their money in the market at the wrong time. People may worry that a stock price is too high, or the market may be about to drop. This fear can often leave investors on the sidelines and miss out on the benefits of long term investing.
DCA is also a way to ensure the investor acquires stock or shares of ETFs at a long-term average price. As share prices fluctuate each month the investor buys different amounts of shares. If an investor buys $1,000 worth of ETF shares each month for a year, at the end of the year they will have used $12,000 to acquire their shares.
How is dollar-cost averaging applied in real life?
Many investors use DCA to fund their retirement accounts. If you’re taking advantage of a Roth IRA or your company’s 401(k), then DCA could be a great way to enforce investor discipline. Each month a sum of money comes out of your paycheck and can be used to invest in the stock market.
This approach has two distinct benefits.
First, it ensures that your retirement savings are being funded because the money is taken out before you receive the rest. This ensures that funds are always allocated to your retirement savings and not spent on something else.
Second, it ensures that the money is actually invested in the market on a regular basis despite the presence of market volatility.
DCA takes the emotion out of trying to time the market and instead makes sure the money is invested on a regular basis by potentially buying more shares when prices are low and fewer when prices are high.