Knowing when to purchase an investment can be tricky, even for the most seasoned investors. Attempting to time purchases at the lowest price possible will almost always lead to disappointment. Fortunately, there is a great way to mitigate the stress of purchasing your investments. This is known as dollar cost averaging or DCA.
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What is Dollar Cost Averaging?
Dollar cost averaging (DCA) is an investment strategy in which an individual has a predetermined investment dollar amount and regularly invests a portion of that money in a consistent time interval, no matter the price. The goal is to reduce the impact of varying prices on the overall cost of the investment, resulting in an average price.
To implement this strategy, an investor can set up a recurring purchase for their desired investment, such as a monthly or weekly automated payment into a certain investment. This will be repeated over time until the investment objective is accomplished. To effectively reap the benefits of dollar cost averaging, the investment dollar amount must remain constant, and the investment must be maintained during the targeted time frame. In the end, this results in an average investment cost.
This method fully eliminates the psychological aspect of trying to time the market. Investors frequently act rashly in response to market swings, resulting in poor decisions or acquiring investments at unfavorable prices.
Another advantage of the DCA technique is that it forces the investor to have a disciplined approach to investing and to stick to their plan. As an investor, developing this personality trait could help to instill patience and conviction in investment ideas.
The Benefits of Dollar Cost Averaging
Dollar cost averaging provides various advantages to investors, including:
Creates an average cost. Purchasing over a period allows the investor to buy more when prices are lower and fewer when prices are high. This results in an overall cost that is average for the period of time. Of course, it would be great to purchase at the lowest price possible, but the chances of that happening are extremely low, even by the best investors.
Lowers the risk of purchasing at an inopportune time. By spreading the purchases over a period of time, it eliminates the chance that the investment is purchased at the highest price. The markets can be irrational, and price changes can happen for unexpected reasons. Spreading your purchases over a period of time mitigates the chances of this happening.
Encourages discipline. Part of being a successful investor requires a tremendous amount of discipline and patience. Choosing an investment plan and committing to it is part of the requirements. Being impulsive can lead to many poor decisions that can cost your portfolio a tremendous amount of potential growth over the lifetime of the investments. Investors that commit to a regular investment plan with DCA builds discipline and patience, which will be rewarded in the long run.
Useful for every investor type. Whether an investor is purchasing for the short term or for the long-term using a DCA approach will provide the ideal way of purchasing at an average price. If the goal is to purchase for a short-term investment, it could mean spreading the purchases over weeks or months. And over months or years for long-term investments.
Investment managers of funds also use DCA. It is extremely rare that a fund will purchase shares over a small period of time but rather spread out the purchases over time.
Example of Dollar Cost Averaging
Ben has worked at his dream job at an innovative tech company for the last several years. In 2017, his annual income was $240K a year, and he’s spending much less than what he’s earning. Investing his hard-earned money is entirely new, but he knows it’s required to secure long-term wealth. So after reading up on investing, he decided to dip his toes into the stock market.
Ben’s research led him to invest in the S&P 500 ETF (SPY) – the foundation of stock market investing. He also has become familiar with dollar cost averaging. Determined to get started but nervous about when to start investing, he decided to invest $3,000 a month. This equates to about 15% of his gross income.
Ben continued this for 5 years, every month, no matter the price.
Here are the results of dollar cost averaging.
Ben spent a total of $180,000 over 5 years.
This equates to $3,000 a month, every month, for 5 years – no matter the price.
He purchased 544.39 shares of the S&P 500 ETF (SPY) during that time.
He paid an average of $330.65 ($180,000/544.39).
Due to market fluctuations over the past 5 years, he was able to purchase shares when the market was down in value and sometimes when it was up.
Ben’s Dollar Cost Average at the end of 2022 is $330.65, which is lower than the year-end price. In addition, there were dividends received over the last 5 years. The dividends totaled $9,372 back into his pocket.
Considering the end prices of 2022 and the dividends paid – Ben has a total current profit of ~$51,900.
Who Should Use Dollar Cost Averaging?
Dollar cost averaging can be a suitable investment strategy for all types of investors, no matter your goals.
New investors. Making your first investment may involve some fear of the unknown. But rest assured, DCA is the correct approach. Investing smaller amounts over longer periods of time can build confidence for your investment future. Baby steps can lead you on your path to success.
Investors who wish to remove emotions from investing. For many investors, the price volatility and monetary value of investments might be daunting. One of the easiest methods to eliminate this and develop confidence is by using DCA. This can help to reduce rash or impulsive investment decisions.
Long-term investors. Dollar cost averaging is the ideal way of long-term investing. Purchasing slowly over a long period of time allows you to purchase shares when prices are low, reducing your average cost per share over time.
Investors with a low-risk tolerance. By spreading out investments over a longer period of time, dollar cost averaging can lessen the risk of investing a significant chunk of money at the incorrect time and losing money as a result.
Investors who struggle with market volatility. Short-term market volatility can lead to unexpected price drops that can be scary for any investor. Using DCA you can purchase more shares at lower prices if volatility occurs. Allowing you to seize the opportunity rather than struggle.
Investors who have a consistent savings plan. DCA is a perfect approach for those that love to save. Investing consistent amounts of long periods of time is the sure way to being a successful investor.
What Types of Investments are Suitable for Dollar Cost Averaging?
Dollar cost averaging can be used for any investment in which your investment is large enough to break it into portions. The most common use of DCA is with stocks, exchange traded funds (ETFs), bonds, Investment Retirement Accounts (IRAs), Health Savings Accounts (HSAs), mutual funds, and commodities. However, many others could be considered but aren’t listed.
Real estate and alternative assets such as collectibles or artwork are more challenging to use DCA. Again, this is due to the availability of assets for sale. If assets aren’t easily purchasable, it can be difficult to use DCA. But if the situation does arise, the same principles apply.
How Do I Implement DCA?
Here are the steps to implement dollar cost averaging in your investments:
Define your investment terms: Determine how much money you want to invest and how long you want to invest.
Knowing how long you anticipate holding your investment is crucial in determining how much time you will want to accumulate that investment.
For example, if you are planning a long-term strategy, you may decide to make investments once or twice a month over the course of years.
If it’s a short-term strategy, you may purchase the investment over several weeks.
Choose an investment: Choose a type of investment instrument, such as individual stocks, mutual funds, exchange-traded funds (ETFs), or bonds. When selecting an investment vehicle, consider fees, risk, and diversification.
Set up a regular investment plan: Determine how much money you want to invest regularly and how frequently you want to invest (weekly, bi-weekly, monthly, etc.). Automated investing can be done very easily with most online brokers. It can be set up as easily as auto-pay for bills and credit cards.
Stick with the plan: Patience and discipline and be the two most difficult parts of investing. Building these two muscles as an investor can be the ultimate key to success.
Monitor your investments: Review your investments on a regular basis to ensure they are functioning as planned and in line with your investing objectives.
Consider rebalancing your portfolio to your desired allocations regularly to ensure that your investments are optimized and diversified according to your plan.
Conclusion
Dollar Cost Averaging is a great investment strategy that is great for both new and experienced investors alike. It helps reduce the pains of trying to time the market by spreading the investment out over time to achieve an average price. Even the best investors know they can’t time the market.
Regardless of your investment skill level or market knowledge, understanding your objectives and implementing a strategy is imperative to building wealth. In addition, practicing DCA over long periods will develop the perfect characteristics of an investor: patience and persistence.
Warren Buffett has one of my favorite quotes for dollar cost averaging. “If you like spending six to eight hours a week working on investments, do it. If you don’t, then dollar cost average into index funds.”
Frequently Asked Questions – FAQ
What is Dollar Cost Averaging (DCA)?
Dollar cost averaging is an investment strategy in which an individual invests a predetermined amount of money at regular intervals, regardless of the price of the investment. This helps to average out the cost of investing over time and mitigates the effects of market volatility.
How does DCA work?
An investor sets up a recurring purchase for their desired investment, such as a monthly or weekly automated payment. This process is repeated over a set period of time, leading to an average investment cost, rather than a cost based on a one-time purchase.
What are the benefits of Dollar Cost Averaging?
The benefits of DCA include lowering the risk of purchasing at the wrong time, encouraging investment discipline, averaging out costs, and being suitable for every investor type, regardless of their investment goals or timeline.
Can you provide an example of DCA in action?
Yes, for example, if you decided to invest $3,000 a month into the S&P 500 ETF (SPY) for 5 years, you’d have spent a total of $180,000. Despite the market’s fluctuations, your average cost per share would be lower, and you’d have received dividends over this time period. This example illustrates how DCA can provide a more stable, long-term return on investment.
Who should use Dollar Cost Averaging?
DCA is a suitable investment strategy for all types of investors. It’s particularly beneficial for new investors, those who wish to remove emotions from investing, long-term investors, investors with a low-risk tolerance, those who struggle with market volatility, and investors with a consistent savings plan.
What types of investments are suitable for Dollar Cost Averaging?
DCA can be used with any investment that can be broken into portions, such as stocks, ETFs, bonds, IRAs, HSAs, mutual funds, and commodities.
How can I implement DCA in my investments?
First, define your investment terms. Decide how much money you want to invest and over what period. Then, choose an investment and set up a regular investment plan, determining how much you want to invest and how frequently. Stick to the plan, regularly monitor your investments, and consider rebalancing your portfolio periodically.
What is a famous quote about Dollar Cost Averaging?
Warren Buffett once said, “If you like spending six to eight hours a week working on investments, do it. If you don’t, then dollar cost average into index funds.”