What is Dollar Cost Averaging?

Dollar-cost averaging is a strategy that can help you deal with volatile markets by automating purchases. It also helps to invest regularly.

Dollar-cost averaging, like most investment methods, is not for everyone, and there are periods when it works better than others. However, it can be an effective strategy for overcoming some emotional hurdles to investing. Here's how dollar-cost averaging works for retail investors.

What is Dollar Cost Averaging?

You can use dollar cost averaging to manage price risk when purchasing equities, exchange-traded funds (ETFs), or mutual funds. 

Instead of investing in a specific asset all at once with a single purchase price, you can divide the amount of money you wish to invest with dollar cost averaging. In doing this, you will buy tiny amounts over time at regular intervals. This reduces the risk of paying too much before market prices fall.

Prices, of course, do not fluctuate in only one direction. However, if you divide your purchase and make many purchases, you increase your chances of paying a lower average price over time. Additionally, dollar cost averaging allows you to put your money to work consistently, which is critical for building long-term wealth.

If you have a 401(k) or any other retirement plan, you're already using dollar cost averaging for at least some of your investment portfolio.

Market Timing vs Dollar Cost Averaging

Dollar-cost averaging works because asset prices tend to rise over time. However, asset prices do not increase consistently in the short run. Instead, there are short-term highs and lows that may or may not follow any discernible pattern.

Many people have sought to time the market by purchasing assets at low prices. In principle, this appears to be a simple task. In practice, even skilled stock brokers cannot accurately predict how the market will move. Next week's low could be a relatively high price. Similarly, this week's peak may be a relatively low price a month from now.

Only in retrospect can you determine what advantageous pricing would have been for any given asset—and by then, it might be too late to invest. When you wait and try to time your asset purchase, you typically wind up buying at a price that has plateaued after the asset has already made significant gains.

How Dollar Cost Averaging Works

Dollar-cost averaging removes emotion from your investing strategy by requiring you to buy the same modest amount of an item regularly. This means you buy fewer shares when the market is high and more when the market is down.

Assume you intend to put $1,200 into Mutual Fund A this year. You have two options: invest your money at once at the start or end of the year, or invest $100 each month.

While it may not appear that the difference between the two approaches is significant, if you stretch out your purchases in $100 monthly increments over 12 months, you may wind up having more shares than if you bought everything at once. Consider the following 12-month outcome:

In the preceding example, you would save 64 cents on your average purchase price by spreading your investments over 12 months rather than investing all of your money at once. You would possess 120 shares of Mutual Fund A if you paid $1,200 for it in January or December at $10 a share.

If you invested $100 in Mutual Fund A every month for a year, your average price per share would be $9.36, and you would possess 128.15 shares.

In this case, dollar cost averaging allows you to purchase more shares at a lower price per share. You will benefit from owning more shares of Mutual Fund A if its value rises over time.

How Can You DCA Your Assets?

With a bit of planning, you can make dollar-cost averaging as simple as investing in an IRA (Individual Retirement Account). Setting up a plan with most brokerages is simple, but you'll need to decide which stock — or, ideally, which well-diversified ETF — to buy.

Then you can direct your brokerage to set up an automatic purchase plan at regular intervals. Even if your brokerage account doesn't have an automated trading plan, you can make everyday purchases on the first Monday of each month.

You can pause your investments if necessary, but the goal here is to continue investing regularly, independent of stock market fluctuations. Remember that declining markets are an opportunity when it comes to dollar-cost averaging.

Dollar-cost averaging is a simple concept, but many people need help implementing it. If you're interested in achieving better long-term returns, consider using Hedgeful. Hedgeful makes dollar cost averaging easy by helping you diversify across major liquid asset classes worldwide. 

Here's one more investment strategy to boost the effectiveness of dollar-cost averaging: Many stocks and ETFs pay dividends, and you may typically direct your stockbroker to reinvest those dividends automatically. This allows you to keep buying the stock and compound your gains over time.

Advantages of Dollar Cost Averaging

Prevents Bad Timing

Timing the market is never a credible long-term investment strategy. Investing in a lump sum at the wrong moment can be dangerous and have a significant negative impact on the value of a portfolio. Because market swings are difficult to foresee, DCA will smooth the cost of purchasing, which can benefit the investor.

Risk Reduction

Dollar-cost averaging decreases investment risk while preserving wealth in a market meltdown. It saves money, which gives you liquidity and flexibility while managing your investment portfolio.

Some market downturns are extended, reducing net portfolio worth even further. Using DCA guarantees a minimum loss and potentially high profits. DCA can alleviate regret by providing short-term downside protection against a rapid decline in a security's price. DCA can significantly improve long-term portfolio return potential when the market begins to rebound.

Ride Out Market Downturns

The dollar cost averaging method, which involves investing modest sums in dropping markets regularly, can help you ride out market downturns. The portfolio utilizing DCA can maintain a healthy balance while leaving the upside potential to improve portfolio value over time.

Disciplined Saving

Adding money to an investment account regularly enables disciplined saving because the portfolio balance grows even when the portfolio's current assets depreciate. A lengthy market fall, on the other hand, can damage the portfolio.

Lower Cost

Purchasing market securities when falling prices offer a more significant return for the investor. Using the DCA method ensures that you buy more protection than if you bought at a high price.

Limit Emotional Investing

Emotional investing, which is caused by various circumstances, such as making a significant lump-sum investment and loss aversion, is not uncommon. Emotional investing is eliminated or reduced when DCA is used.

A disciplined buying technique using DCA directs the investor's attention to the work. It avoids news and information hype from various media outlets about the stock market's short-term performance and direction.

Disadvantages of Dollar Cost Averaging

Priority Asset Allocation

DCA detractors believe that an investment strategy should prioritize the intended asset allocation to manage risk. Pursuing a DCA will increase uncertainty because the target asset allocation parameters will take longer to reach. Because the economic and physical environments change over time, investors must be able to realign their portfolios to guard against loss and capitalize on new opportunities.

Complicated

The process of monitoring each scheduled payment over a particular time horizon is laborious, especially when the cost difference compared to a lump-sum investment is minor. Monitoring and tracking each contribution takes time and effort, making it more complex than a lump-sum investment.

Increased Transaction Costs

By purchasing securities in modest sums over time, investors run the danger of accruing substantial transaction fees, which can undercut the profits made by the portfolio's present holdings.

However, it will mostly depend on the sort of investment plan, as certain mutual funds have a high expense ratio, which can have a negative impact on portfolio value over the medium to long term.

Low Expected Returns 

High risk-high rewards and low risk-poor returns. As a result, using a DCA strategy to decrease risk will necessarily result in reduced returns. 

The market often sees longer-lasting bull markets with rising prices than bear markets with falling prices. As a result, a DCA investor is more likely to miss out on asset appreciation and more significant rewards than a lump sum investor.

Conclusion

The primary benefit of dollar-cost averaging is that it mitigates the negative effects of investor psychology and market timing on a portfolio. With DCA, investors eliminate the possibility of making counter-productive decisions such as purchasing more when prices are increasing or panic-selling when prices are falling.