What is Dollar Cost Averaging and How Does it Work?
As with any investment, the objective of dollar cost averaging is to buy low and sell high. However, this concept is in fact notably complex to execute in the real world—particularly with respect to stocks, which are sometimes extremely volatile and thus make it virtually impossible to predict the perfect time to buy or sell shares. Nevertheless, dollar cost averaging (DCA) is one specific tool that can help minimize the risk of buying too high. Let’s explore this concept further.
An overview of dollar cost averaging
Dollar cost averaging is a long-term investment strategy wherein you spread out your equity purchases (stocks, funds, etc.) over regular buying intervals and in roughly equal amounts—rather than as one lump-sum purchase.
For example, instead of purchasing $24,000 of Apple stock in one fell swoop, you’d buy $1,000 worth of Apple shares every month over a 24-month period.
How dollar cost averaging benefits investors
The objective of dollar cost averaging is to minimize risks associated with market volatility. Let’s assume you decide to invest $1,000 a month by purchasing shares of Apple. Fluctuating stock prices will push costs higher during some months—impacting your ability to buy so many shares—while the cost of Apple stock will fall in other months (meaning you can purchase additional shares with that same $1,000).
The theory here is that over time, your cost per share will likely compare quite favorably to a lump-sum purchase option wherein you aim to perfectly time the market to score the best price (which is, in fact, very unlikely); dollar cost averaging ultimately smooths your purchase price over time to help ensure you won’t dump all your money into the pot at the highest point.
Another advantage of dollar cost averaging is that it quells the emotional side of investing. As many investors often react strongly when their stock price drops significantly, they often bail out and miss out on potential rebounds the investment goes on to experience (a scenario particularly prevalent when a large amount of money is invested in a single trade via a lump-sum purchase). By continuing to buy additional shares with smaller sums of money over time, it’s much easier to stomach a poorly timed investment.
Finally, dollar cost averaging also helps establish good investing habits: fostering discipline and discouraging investors from spending money earmarked for specific investments.
Dollar cost averaging drawbacks
Some experts deem dollar cost averaging less effective in a bull market wherein prices continually rise. While correct in theory, this scenario rarely plays out in real life as stocks almost always remain volatile—even in rising markets. That said, markets do tend to rise in value over time; therefore, a lump-sum approach can provide a more significant return when markets gain steam. Then again, choosing a suitable investment is even more critical in this case to increase the likelihood of a successful lump-sum strategy.
Any investment strategy, including dollar cost averaging, is only as good as the investments one selects. Therefore, if you invest in a stock that goes on to disappointment you with a poor performance, a DCA strategy won’t magically transform your bad choice into a good one.
How to establish a dollar cost averaging plan
Executing a DCA strategy is simple, and you’re perhaps already doing so without even realizing it—particularly if you contribute to a workplace retirement plan such as a 401(k).
To illustrate, let’s assume you contribute to a 401(k) plan every pay period. As most of these plans typically invest in an exchange-traded fund (ETF) or mutual fund, each paycheck contribution buys you additional shares of the same.
As with any stock, the value of underlying funds will fluctuate over time; in some months, you’ll receive more shares of the fund or vice versa when prices rise. This exercise in systematic investing can help you smooth out the purchase price over time and, in turn, implement a dollar cost averaging strategy.
Other dollar cost averaging considerations
Because dollar cost averaging means you’ll execute trades on a more frequent basis, this strategy does add to overall trading costs. These fees fade to the background compared to the overall value of your portfolio over time, however, especially since brokerage firms are now charging less than ever to make trades under current conditions. Nevertheless, if you’re concerned about this, remember that no-load mutual funds are traded in the absence of commission fees and represent a viable investment choice for your dollar cost averaging strategy.
Regardless of the amount invested, dollar cost averaging shines through as a long-term strategy given the need to experience corresponding highs and lows to see actual value. Consequently, you’ll generally want to hold on to your investment for at least five years if you decide to go this route.
In sum: dollar cost averaging
As with any investment strategy, dollar cost averaging has both pros and cons and is therefore only suitable for a specific batch of investors. While DCA offers an excellent way to slowly build wealth for investment newbies—particularly those favoring a “set-it-and-forget-it” approach—experienced investors with a large appetite for risk and/or seeking the flexibility to move funds (especially in light of increased exposure) may need to look elsewhere for their ideal investment strategy.
FAQs
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Dollar cost averaging is often a valuable investment strategy, but the frequency of implementation ultimately depends on several factors. It’s first important to consider your investment horizon, meaning the duration of time you expect to hold your investments; using DCA on a regular basis is sometimes beneficial for those with a long-term horizon, specifically. Your market outlook also plays a significant role in determining frequency. If the market is experiencing fluctuations but you believe it will eventually rise, implementing dollar cost averaging is often a suitable approach. A persistent bear market, on the other hand, renders this strategy less advantageous. Furthermore, your personal investing experience can influence how often to employ dollar cost averaging. If you have limited experience or are brand new to investing, regular and consistent implementation of this strategy may be beneficial: allowing you to gradually build your investment portfolio and mitigate the impact of market volatility.
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Extending to various investment vehicles beyond 401(k) plans, dollar cost averaging can be utilized within tax-advantaged accounts (e.g., traditional IRAs or taxable brokerage accounts) and thus enable investors to make regular mutual/index fund purchases. Brand-new investors interested in trading exchange-traded funds (ETFs) can also greatly benefit from DCA, while dividend reinvestment plans often facilitate this strategy by allowing investors to make regular purchases—offering yet another avenue to effectively utilize dollar cost averaging.
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Yes, employing a DCA strategy with index funds is considered less risky than doing the same with individual stocks—especially when investors have limited knowledge in this field.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
