Dollar-Cost Averaging (DCA): How It Works, Benefits & an Example

Introduction

There’s no doubt that investing can be stressful, especially if you’re attempting to time the market and buy at just the right time, when prices are low and likely to increase.

Dollar-cost averaging is a proven strategy that can mitigate some of that uncertainty. It can reduce the emotional roller coaster and help you keep investing even if the market is in a challenging moment.

If this sounds good, keep reading to learn more about DCA and understand if this could be a good strategy for you.

What is dollar-cost averaging?

DCA is an investing strategy where you invest a fixed (usually smaller) amount of money, over a long period of time.

With DCA it doesn’t matter if the price is fluctuating, you keep investing the same amount regularly, which means you buy more shares when the price is low and fewer shares when the price is high.

This might seem counterintuitive at first, but there are interesting advantages to consider, particularly for long-term investments like retirement plans.

In fact, if you have a 401(k) plan or some similar contribution with a fixed amount regardless of market variations, you’re already using dollar-cost averaging in your portfolio.

The name of this strategy comes from the benefit one might get by using it: buying more shares over a period, at a lower average price compared to what you’d be paying if you invested a huge sum of money all at once.

In a perfect world, of course, investors would buy lots of shares at just the right moment, and at the perfect price. But that is not a realistic scenario. Even for experienced investors who do their own advanced research, it’s nearly impossible to predict the ups and downs of the stock market. It’s only looking back that patterns become clear, and by then it’s too late to buy.

How dollar-cost averaging works

DCA is a great opportunity to strengthen the habit of regular investments, minimizing the psychological effects caused by market volatility.

Let’s say you have $600 to invest. You could spread that amount over six months, investing $100 each month. Alternatively, you could invest the whole sum at once, at a specific moment in time.

At first glance, it might seem like those two options wouldn’t result in that much of a difference. But in reality, by spreading out your investments over time, you could pay a significantly lower average price for each share.

This happens because of two factors:

1. Price fluctuations

Prices will always vary, and knowing when it’s the right time to buy is challenging. By using dollar-cost averaging, you reduce the risk of investing a large chunk of money at the wrong time.

2. The power of the average

Suppose you chose to invest all of your $600 when the price was higher than the average. You would then walk away with fewer shares than if you had used the dollar-cost averaging strategy.

Of course, this is only a hypothetical scenario. You could have been lucky enough to buy everything at just the right time, at a lower price than the average. But how often would that be the case? Many try to time the market, but few actually succeed.

That’s why DCA can bring a little more certainty and peace of mind by investing over longer periods of time.

Benefits of dollar-cost averaging

Cover_image_(2).jpg

Interested in trying DCA in your next investments? Take a look at some of the benefits you can enjoy with this method:

It can help create persistent investing habits. It’s not easy to invest regularly, especially when the market is down. By using DCA you force yourself to keep going with your long-term investment plans.
It can lead to less stress and reduce the weight of emotional decisions. Since you’re investing in an automatic manner, it’s harder to fall for the temptation to panic-sell or to euphoric-buy.
There’s no need to keep checking the market constantly and worrying about short-term fluctuations. You’re less prone to follow trends that might damage your returns in the long run.
It reduces the timing risk of buying only when the prices have already reached their peak. By spreading your purchases over time, you’ll buy at different prices and make the best of your available resources.
Another great advantage is that you’ll be ready to buy when the prices reach their lowest value. You’ll be at the door when opportunity knocks and won’t miss out on any major favorable circumstances.
DCA will reduce your average costs over time, making sure you walk away with more shares and that you pay a lower average price for each one. It’s not infallible, but the numbers show that is usually the case when you analyze an asset over time.
Dollar-cost averaging is an easy strategy for beginners to implement and can also be a nice option for those who do not have large sums of money to invest at the beginning of their journey.

Warren Buffett, the chairman and CEO of Berkshire Hathaway, has famously shared his views on trying to always time the market.

“

“It’s a terrible mistake to think of stocks as something that bobs up and down, and that you should pay attention to those bobs up and down.”

Warren Buffett

Drawbacks of dollar-cost averaging

Despite being a valuable strategy for a lot of different investors, it’s important to consider some of its downsides:

It could cause missed opportunities if the market rises continually since you would end up buying fewer shares compared to the number you would have purchased with a big sum before the prices increased.
It’s a method that works best for volatile assets. The DCA would protect you from the volatility, ensuring you keep investing through thick and thin.
Like any other investment strategy, dollar cost-averaging doesn’t guarantee profits. Depending on the market situation, especially with sudden and deeper changes, you might suffer some losses.
Likewise, DCA won’t protect you from constant declines. For this plan to work, the price of your asset must be rising overall, even if it dips occasionally.
It could be particularly good for index funds and similar assets, since they are somewhat predictable in trying to follow a market index. It will be far riskier for stocks, and eventually, you will have to check your portfolio at least once in a while.
It’s important to keep attention to trading fees that you might encounter because of regular investing. It might be worth checking that information beforehand with your brokerage company.

In summary, dollar-cost averaging may be a good method to mitigate your risks, but it can also mean that you may miss out on bigger returns.

Who should use dollar-cost averaging?

DCA can be a rewarding investing strategy for many types of investors, including:

Inexperienced ones. It’s hard enough to start a regular habit of investing, especially if you try to learn too many things at once in an attempt to time the market. That’s where dollar-cost averaging can help, making things more simple and straightforward.
Investors focused on the long term, particularly with retirement accounts. With DCA it’s easier to keep your eyes on the prize and not be tempted by market variations. Also, investments will be automatic and easier to manage.
Investors with limited capital to invest. For those who have less, it can be a way to start investing right away, rather than wait for a huge sum of money that might not be available in the near future.
Investors who are not interested in doing extensive market research. It can be stressful and frustrating trying to time the market. Some people enjoy that, but it’s not for everyone.
Investors who want to decrease their risk, even if that means losing the possibility of greater returns. DCA can be a predictable and steady way to invest, especially with index funds and similar securities.

Example of dollar-cost averaging

Like before, suppose you have $600 to invest. In this example, you could invest everything at once, or you could spread your resources over 6 months. Here’s how things could play out with dollar-cost averaging:

MONTH	INVESTMENT	SHARE PRICE	SHARES PURCHASED
1	$100	$5	20
2	$100	$4	25
3	$100	$2	50
4	$100	$4	25
5	$100	$5	20
6	$100	$4	25
—	Total: $600	—	Total shares purchased: 165

In that hypothetical scenario, you invested $100 each month and bought 165 shares at an average price of $3.63 each.

Now let’s see it without DCA:

MONTH	INVESTMENT	SHARE PRICE	SHARES PURCHASED
1	$600	$5	120
2	$0	$4	0
3	$0	$2	0
4	$0	$4	0
5	$0	$5	0
6	$0	$4	0
—	Total: $600	—	Total shares purchased: 120

As you see, if you had invested the whole sum at month 1, you would have bought only 120 shares at an average price of $5 each. That’s 45 fewer shares and an increase of $1.37 in the price of each share.

Of course, in a perfect world, you would have invested everything at month 3 and then you would have 300 shares for $2 each. But what are the chances of you correctly predicting that? How about every time? Even for experienced investors who do extensive research and check the market frequently, it’s a tough game to master.

That’s why dollar-cost averaging can give you some certainty and reliable gains without that additional stress. Just keep reinvesting regularly and eventually, the results will come.

Common mistakes to avoid when using DCA

As with every investment strategy, there are some common mistakes that you should avoid:

If you have a large sum to invest and a trusted asset with a good price, you might be better off investing everything all at once. This could vary, but depending on the asset, a big lump sum investment will perform better.
Since you’ll be investing regularly, don’t forget to check transaction fees and commissions. They could add up and eat a significant portion of your gains.
DCA assumes that ultimately the price of an asset will rise. It won’t protect you if the market consistently declines or if your chosen asset underperforms.
If you’re investing for the short term, DCA might not be for you.
If you enjoy researching the market and changing your portfolio accordingly, DCA also might not be for you.
As with many investing methods, a diversified portfolio is best when using DCA.
It’s crucial to actually invest at regular intervals to make sure you maximize the benefits of DCA. Even skipping only two or three months could make a difference in how the averages perform.

Summary

Dollar-cost averaging is a great proven investing strategy that could help both novice and experienced investors maintain a healthy habit of regular investments, without needing to constantly monitor the market’s ups and downs.

While there are some downsides to consider, it can be a powerful tool to grow your returns over longer periods of time, even if you don’t want to play the market timing game.

As with any investment strategy, consider carefully how DCA will fit into your macro investment goals, and how it could help you reach them faster, with less stress.

As always, count on FBS to keep you well informed and to help you with all your trading needs.

Dollar-Cost Averaging (DCA): How It Works and an Example