Dollar-Cost Averaging (DCA) Explained For Beginners (2024)

Investing can be challenging regardless of the broad market sentiment. Short-term fluctuations can easily turn a potentially profitable trade negative. To combat this, some investors choose to ignore the short-term price movements of a stock and look at the fundamentals to decide whether to commit their capital to the stock or not. If the stock has solid fundamentals, investors will start to buy up the same dollar value of the stock at regular intervals. This is called dollar-cost averaging and involves investing a fixed amount of money in an automatic fashion to negate the effects of short-term price fluctuations. Such an investment strategy requires a lot of confidence in the target stock in the long run. Thus, the strategy is geared towards long-term investors who are not interested in timing the market to get the best possible purchase price.

The rationale behind dollar-cost averaging is that consistently using the strategy can lead to investors buying up more stocks at lower prices and less at higher prices, which lowers the overall purchasing price. Poorly-timed lump sum investments can be risky and DCA seeks to offer an alternative to investors by dividing purchases into parts of equal value.

Understanding what DCA is and how it works can be a great addition to investors’ strategies.

“..I wouldn't toss a chunk in at any one time, I would do it over a period of time..” - Warren Buffett

Dollar-cost averaging, or DCA for short, is an investment strategy commonly used by investors who wish to build up their holdings, in particular stocks, over a longer period of time. Depending on the investors, budget, the average investment amount can vary greatly, but the overall process is typically the same across the board:

• Investor chooses the amount they would like to invest, as well as the stock(s) they would like to invest in
• They choose a recurring time period for their investments. The most common frequency is once a month
• The investor keeps buying the stock until a certain date - ignoring the going market price of the stock

The main idea behind DCA is that a stock with solid fundamentals and good long-term growth potential, will be able to generate acceptable returns in the long run. Dollar-cost averaging simply removes the pressure of trying to time the market and focuses on the fundamental developments around the company issuing the stock. 401(k) plans typically offer employees dollar-cost averaging strategies, where they can choose the amount they wish to contribute. The investments are then made automatically per pay period.

Dollar-cost averaging is a convenient investment strategy for investors who do not have the time or expertise to actively trade on the stock market but would rather choose a handful of stocks that they like and buy up these shares on a regular basis. Stock prices fluctuate all the time, which means DCA could allow investors to buy at favorable prices. For example, buying a stock at a higher price and continuing to buy as the price falls will lower the average price paid per share for the investor.

While DCA might not be a universal investing solution, it does remove the fixation on short-term price fluctuations from the picture and allows investors to focus on the fundamentals of the issuing company to decide whether to continue buying up their stock or not.

To better understand how dollar-cost averaging works in practice, let’s look at examples of how the strategy could perform during falling and rising market trends.

"Dollar averaging is a good way if you have a lump sum to invest to make sure you're going like spread out over four years, do it every quarter or something like that five years, and that's a conservative idea" - Jack Bogle

Falling Market

Let’s assume an investor splits a $5,000 investment in XYZ stock into 5 installments at $25, $22, $20, $17, and $14. This would amount to 255.7 shares of XYZ stock. After some time, the investor sells their holdings. Different selling prices can show us the returns generated in a falling market trend:

As we can see, the investor would actually profit after selling the stock at $23, which is lower than the highest purchasing price of $25.

If the investor had invested $5,000 at $25, this would only give them 200 shares (assuming there are no commission charges). Selling 200 shares at $23 would result in a $400 net loss, as opposed to the $881 profit in the case of dollar-cost averaging.

Rising Market

Continuing our example, let’s assume the scenario is the same, but the investor starts selling once the stock price starts to increase from the $14 lowest purchasing price. The investor’s 255.7 shares would result in the following returns:

As we can see, profits increase substantially as the price also increases. This is due to the fact that the average purchasing price for a single share of XYZ is (14+17+20+22+25)/5=$19.6, as opposed to the lump-sum price of $25.

Overall, dollar-cost averaging is a less-risky alternative to lump sum investments, which can be especially susceptible to sudden price fluctuations in the market.

Dollar-cost averaging can be done in several ways. If you have a 401(k) savings account, you can set up a plan with your brokerage by instructing them on the frequency and size of investments that are to be made on your behalf.

If your brokerage does not offer automated investments, you can set time constraints on your buy and sell orders and manually construct a DCA strategy.

Many stocks also pay dividends and instructing your broker to reinvest them can amplify your dollar-cost averaging strategy. You can also suspend your investments if you need to. Although, dollar-cost averaging works best when it is employed in a continuous fashion over long periods of time. For this reason, blue-chip stocks tend to be the most popular among DCA investors.

While DCA can be a viable long-term investment strategy, it does come with a fair bit of drawbacks. Let’s look at some notable advantages and disadvantages that come with dollar-cost averaging strategies.

Pros

• Lower average spend on investments
• Removes the hassle of trying to time the market
• DCA is done automatically and is considerably less stressful than lump sum investing
• The ability to take advantage of lower prices when buying and higher prices when selling
• Buying more shares at a lower average price than when buying lump sum

Cons

• Geared towards long-term investors
• Performance difference can be negligible during periods of market stagnation
• Not a viable substitute for identifying good investments
• Reduces the maximum potential gain from investments

• Dollar-cost averaging is an investment strategy where investors consistently invest the same dollar amount in a security over a period of time
• DCA can be a beneficial strategy for experienced investors and beginners alike
• Dollar-cost averaging is especially popular among investors with retirement accounts, such as 401(k)-s
• Most brokers offer automated investing services, which can be used to implement a dollar-cost averaging strategy
• While DCA may remove stress from investing, it also limits the maximum potential returns over a longer time frame