Dollar-cost averaging, or DCA, is an investment strategy that reduces market risk by spreading out the purchase of a security over several smaller purchases.
What Is Dollar-Cost Averaging?
Dollar-cost averaging (DCA) is an investment strategy whereby an investor makes multiple purchases of an asset over a period of time, realizing several different entry prices. A DCA strategy can reduce the volatility of an initial investment because the investor makes purchases over regular intervals, as opposed to all at once. Dollar-cost averaging can be achieved via the setup of an automated investment program, or through an investor's own judgments of when to making follow-up investments.
Dollar-cost averaging can be achieved with a 401k plan, where the investor chooses a dollar amount or a percentage of their income to be regularly invested in their pre-selected investment choices, which are typically mutual funds.
Some investors don't use an automated investment program, but choose to 'double-down' on an investment they hold if it's fallen in price, lowering the average cost.
How Dollar-Cost Averaging Works
The way a DCA strategy works is that periodic deposits of cash will go to buy shares of an investment at multiple price points, which combine to form an "average" price.
Dollar-Cost Averaging Calculation
The calculation for dollar-cost averaging works the same as calculating the average or mean for a set of numbers. In the case of DCA, the investor adds investment purchase prices, then divides the sum by the amount of purchases made.
Here's the dollar-cost averaging calculation formula:
Average Cost = Total capital invested / number of units received
Dollar-Cost Averaging Example
For a simple dollar-cost averaging example and calculation, let's say an investor buys $100 per month in shares of a mutual fund. After five months, the investor reviews the purchases and sees that they bought mutual fund units at different price purchase points, which were $50, $49, $48, $47, and $51.
The initial $100 investment would have bought the investor 2.00 units of the fund ($100/$50 = 2.00). For the subsequent investments, the investor would have received approximately 2.04. 2.08, 2.13, and 1.96 units, respectively. The total number of units received from the five $100 outlays would have been approximately 10.21.
The average cost can be calculated by dividing the sum of the dollars invested by the number of units received:
Average Cost = $500 / 10.21 = $48.97
In this example, had the investor purchased $500 of the mutual fund at the very beginning, they would have received 10.00 units, and realized an average cost of $50/unit. The investor whose dollar-cost averaged received 10.21 units, and realized a lower average cost of $48.97.
It's worth noting that dollar-cost averaging doesn't always result in a lower average cost. If the price of the security rises following the first purchase, and remains at that higher price, the average cost realized will be higher.
Important: Share accumulation is important to building wealth over time, especially for long-term investors. Accumulating shares over time will achieve results similar to dollar-cost averaging.
Mutual Funds for Dollar-Cost Averaging
Many investors choose mutual funds as the vehicle for dollar-cost averaging because usually funds can be purchased through either a fixed dollar amount or fixed number of units. While some brokerage firms allow investors to buy fractional shares of stocks, enabling a fixed-dollar DCA program, some brokerages don't allow it.
Dollar-Cost Averaging vs. Lump-Sum Investing
One of the main drawbacks to dollar-cost averaging is that it can lead to lower investment appreciation if markets are rising. Investing a lump sum would deliver higher returns than a DCA program if the initial purchase date(s) occurred when investment prices were at a near-term low point.
Important: Dollar-cost averaging doesn't always result in a lower average cost than investing all at once. A DCA program will always achieve an average cost, but when investment prices are rising, that average cost can be higher than the cost of an initial lump-sum outlay.
Pros & Cons of Dollar-Cost Averaging
Pros of Dollar-Cost Averaging
- Reduces timing risk: Since DCA involves investing at regular intervals, the risk associated with the timing of an initial investment is reduced.
- Automatic investing: For many investors, an automated DCA setup can help them keep their savings and investment goals on track.
Cons of Dollar-Cost Averaging
- Potential for higher trading costs: Some brokerages charge commissions or transaction fees for trading. Even if these trading costs are low, they can add up over time and diminish an investor's net returns.
- Potential for lower returns: Although dollar-cost averaging can help reduce timing risk, a DCA strategy can be financially disadvantageous when prices are steadily climbing higher.
How To Invest Using Dollar-Cost Averaging
To realize dollar-cost averaging, investors can establish an automated DCA plan or manually make periodic purchases. The basic steps for an investor to set up DCA are to choose the investment, determine a dollar amount to invest, choose an investment frequency, and decide if they want to make manual purchases or set up automated deposits.
The steps to set up a dollar-cost averaging plan are:
Step 1: Open an Investment Account
To set up a DCA plan, you'll need some type of trading account, such as a brokerage account or an individual retirement account (IRA).
Step 2: Select the Investment
Decide which investment you're interested in achieving dollar-cost averaging for, such as a mutual fund, ETF, or stock. Many brokerage firms and investment companies allow investors to choose multiple investments for periodic, systematic investing.
Step 3: Choose a Dollar Amount to Invest
Some brokerage firms may require a minimum period investment amount, such as $100 per trade, but otherwise, the decision of how much to invest is up to the investor. In setting up a DCA program using an IRA, investors need to make sure that their purchases do not exceed the annual maximum contribution level.
Step 4: Automate the DCA or Make Manual Purchases
Investors can setup a DCA program using their preferred dollar amount and investment frequency, or manually achieve dollar-cost-averaging by initially investing a partial position and then making additional purchases later on.
Tip: An automated DCA strategy can be established for a set time frame or continue indefinitely. For example, an investor could select a pre-determined end date, such as 12 months from now, at which point automated purchases would end. Alternatively, the investor can elect to not choose an end date, which means that the DCA will continue until further instruction is received.
Bottom Line
Dollar-cost averaging can be a smart way for investors to reduce timing risk of their investments by instead making regular, periodic purchases over time. A DCA strategy won't necessarily help an investor increase the returns on their investments but it can be an easy and affordable way to build wealth over time.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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