Dollar-cost averaging (DCA) is an investment strategy in which you invest a set amount of money at regular intervals. In most cases, you select a few target securities that you feel will perform well over the long term. Then you continue to invest the predetermined amounts regardless of changes in stock price.
By spreading out your stock purchases, you better capture long-term trends, are less impacted by market timing, and can build strong investment habits. There are multiple benefits to choosing the dollar cost averaging strategy, which we outline later in this article. But the only real disadvantage is catching the market on an upswing. If you start DCA at a low point in the market, and the price of the stock steadily climbs over the next few months or years, you’ll have missed out on a lot of potential growth that you could have reaped from with a large lump sum. This is why dollar cost averaging is great to use on securities with fluctuating stock prices.
Let’s take a look at a few examples of how dollar cost averaging can work for you:
6-Month High Volatility Example
Imagine you’ve decided to buy a tech stock, QRS because your research has revealed this company has major potential. With dollar cost averaging, you will spend $50 a month on QRS stock.
January – $4 per share for a total of 12.5 shares.
February – $2 per share for a total of 25 shares.
March – $1 per share for a total of 50 shares.
April – $10 per share for a total of 5 shares.
May – $10 per share for a total of 5 shares.
June – $2 per share for a total of 25 shares.
Over a six-month period, you purchased – 122.5 shares. You spent $300, so your average stock price is $2.44 per share.
If you had purchased a $300 lump sum of QRS in January at $4 per share, you’d have 75 shares. And your average stock price would be $4 per share.
Even though you purchased some shares at $10 with the dollar cost averaging approach, you also were able to next a bunch of shares a $1 and $2. You are now positioned better if this stock price increases in the future.
If you stopped investing in this stock now, and it rose to $7 a share ($857.5 value for 122.5 shares), you’d profit $557.5. If you invested $300 in January and didn’t purchase any more stock ($525 value for 75 shares), you’d only profit $225. With dollar cost averaging, you doubled your profits!
12-Month Low Volatility Example
For this example, you have decided to buy a utility stock called XYZ. You will be spending $100 a month over the next 12 months.
January – $4 per share for a total of 25 shares.
February – $3 per share for a total of 33.3 shares.
March – $3 per share for a total of 33.3 shares.
April – $3 per share for a total of 33.3 shares.
May – $2 per share for a total of 50 shares.
June – $2 per share for a total of 50 shares.
July – $3 per share for a total of 33.3 shares.
August – $2 per share for a total of 50 shares.
September – $4 per share for a total of 25 shares.
October – $5 per share for a total of 20 shares.
November – $5 per share for a total of 20 shares.
December – $3 for a total of 33.3 shares.
If you notice, this stock was much less volatile than the previous example. Over the past 12 months, you have purchased 406.5 shares for $1200. This gives you an average share price of $2.95.
If you had dropped all $1200 in January when the cost of each share was $4, then you would only have 300 shares right now.
You are much better poised for growth with the DCA strategy. If this stock rises to $10 a share, your 406.5 shares will be worth $4065. With a $1200 investment, you’ve made $2685. But without dollar cost averaging, this same $1200 investment only yields an $1800 profit when dropped as a lump sum.
5 Reasons to Use Dollar Cost Averaging
1. New Investor
If you’re new to investing, you are probably overwhelmed by how to get started. Which stocks do you buy? What is an index fund? What about bonds? When is a good time to buy stocks? How many shares?
If you find that you don’t know the answer to these questions, then you are probably too new to investing to be strategizing. Instead, you need a straightforward approach to investing. With dollar cost averaging, you don’t have to worry much about timing. As long as you invest in a solid security, it’s a good approach for beginners.
2. Timing the Market
Many investment professionals maintain that timing the market is impossible. Even day traders and mutual fund managers can’t time the market 100% of the time. You can research stocks, study trends, and watch for signals all day, but it may not pay off. With DCA, the only thing you have to research is what security to invest in. Once you’ve made that decision, the rest is cake.
3. Build Investing Habits
Random investing isn’t a good strategy. Consistent investments are the way to go. The dollar cost averaging strategy is all about investing at regular intervals. This strategy doesn’t require a set dollar amount. So no matter what your budget is, you can get started. But the important thing here is the investment habits you are building.
Starting off small and simple, you set yourself up for long-term investment success. Over time your investing budget may increase, and you’ll slowly accumulate more and more stock. And when you’re a more experienced investor, you can start branching out to different strategies to see what you like best.
4. Long Term Strategy
Your investment portfolio won’t be built in a day. Unless you have major cash to dump into the market, it’ll take time to build up a significant number of securities across several market areas. DCA mitigates many of the risks associated with investing because you’re favoring long-term with smaller investments over entering the market with a big investment that you later realize was poorly timed. With dollar cost averaging, you catch the highs and lows of the market.
5. Emotional Investing
One of the hardest things to remove from your investing strategy is your emotional response. When the market is doing poorly, you may feel the urge to sell your stock, so you don’t lose your entire investment. But that is one of the worst things you can do. While you will never 100% know where the stock floor or ceiling is, you should avoid selling out of fear.
Most stocks will recover and head into new highs if you can hold strong during the lows. DCA helps you hold strong. You will continue to invest your normal amount at regular intervals, regardless of whether the market is high or low. This helps you avoid your price fears and stay the course.
Learn Build Profit is a financial literacy blog providing expert insights on income investing and passive income generation through dividend stocks and real estate.
