What is Dollar Cost Averaging?
Dollar cost averaging is an investment strategy of buying the same amount of a particular investment on a regular schedule, regardless of the share price.
Dollar cost averaging (DCA) can be the perfect investing plan for you because you don’t try to “time the market.” If you have a penchant for buying high and selling low, maybe you should consider dollar cost averaging. Let’s learn more about it. DCA is an investment strategy of buying the same dollar amount of a particular investment on a regular schedule, regardless of the share price.
Dollar Cost Averaging Invests the Same Amount Each Month
Dollar cost averaging invests the same amount each month.
If you contribute to a 401k plan, you are already using this investment strategy! Every month, your employer automatically withhold the same percentage of your salary. If you make $2,000 per paycheck and contribute 10%, $200 is automatically invested every month.
Assuming you get paid twice a month, you will contribute $4,800 a year ($400 per month).
You will also make your contributions on the same day each month–the 1st and 15th for example if those are your regular pay dates.
For your non-401k accounts, you will usually only make a single monthly contribution. It can be at the first of the month or after you receive your paycheck to ensure you don’t overdraft your bank account.
Dollar Cost Averaging vs Lump Sum Investing
If you were to do lump sum investing instead, you might contribute the entire $4,800 at once or in several large blocks like $2,400 each. You might invest a lump sum for the following reasons:
- Inherit a windfall
- Invest when money is available
- Year-end retirement account contributions
- Not enrolled in automatic monthly contributions
The Best Option for “Set It and Forget Investors”
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For simplicity’s sake, dollar cost averaging is the easiest investing strategy because you budget the same amount every month for investments.
Many brokerages and robo-advisors make it easy to signup for dollar cost averaging because some only require a minimum investment of $1. While your brokerage doesn’t tell you this is how you’re investing, you are indeed dollar cost averaging.
As a “set it and forget it” or “buy and hold” investor, you’re not trying to time the market. While it’s always nice to try and buy stocks on a down day, you may end up not buying at all if you stock prices continue to rise. At the end of the day, it’s better to have your money invested so it can begin earning compound interest; regardless of the price and market momentum.
Advantages of Dollar Cost Averaging
There are several key positives of dollar cost averaging.
Easy to Budget
If you like having a constant monthly budget, dollar cost averaging makes it easy to calculate how much you invest every month. You will always invest $200 a month, not $100 one month and $400 three months later because you skipped a few months.
And because you know you will be investing the same amount every single month, you can plan your monthly expenses accordingly; investing becomes a priority instead of an afterthought.
You Never “Time the Market”
An old investing cliche is “buy low and sell high.” Unfortunately, this is easier said than done for most investors. If you tried this tactic, you have probably realized how the market is unpredictable and it’s easy to lose money if you invest incorrectly.
While dollar cost averaging won’t guarantee a positive return or even the best return every single year, you will still get monthly exposure to the stock market and you buy regardless of the current share price or momentum.
Your 6-month monthly contribution might look something like this:
Even though the share price fluctuates above and below the initial $100 share price, the average price you pay is $100 over this six month period.
Because we can’t predict what the stock market will do one day from the next, dollar cost averaging helps take some of the emotion out of the investing equation. If you are prone to panic selling and don’t like the market volatility, making the same investment on the same date each month reduces the risk of selling too soon and having a nervous breakdown.
Spreading your investment over the course of a year also means you won’t potentially lose your entire investment in case you make a large lump-sum investment and the stock price drops sharply next week. For example, if your $5,000 investment drops 20% in one day, it will only be worth $4,000 instead of $5,000. Sudden drops like these have scared novice investors and now they don’t invest and risk not being able to retire on time.
Buy Fewer Shares When Prices Are High
By committing a fixed amount each month, you buy however many shares your contribution can afford. When prices are low, you get more shares–buy 5 shares for example. As the share price increases, you might only be able to buy two shares.
If you wait to do a lump sum investment at the end of the year, you might have missed out on the lower prices and appreciation–that means less passive income because the shares might not have as much room to climb.
Once you are ready to sell your shares, you will (theoretically) have more to sell because you bought low and are selling high!
Disadvantages of Dollar Cost Averaging
Even though there’s a lot to like about dollar cost averaging, it’s not always the best option.
Commission Fees Eat Into Returns
Unless you trade no-fee mutual funds and ETFs, you will pay a trading commission of $4.95 or higher to trade stocks and commission-based ETFs. If you make two trades a month, those commissions wipe out the first $120 in dividend income you earn.
You Might Miss Sharp Market Upturns
Very few, if any, experts predicted the 2017 stock market rally would be as robust as it was. If you invested the entire lump sum in January 2017, you would have captured the entire 12-month rally. Even though you still would have turned a profit in 2017 from dollar cost averaging, your returns probably won’t be as high if you invested in an index fund that tracks the performance of the broad market.
For investors with small budgets, dollar cost averaging is the best way to invest on a regular basis. It limits market risk, and prevent emotional investing. And, it helps ensure you capture the current market momentum instead of missing out on a massive rally because you were waiting for share prices to drop before you made a trade. It could take years for prices to drop to “bargain levels” again or you end up paying more and missing out on a portion of the rally.
If you haven’t done so already, you might want to give dollar cost averaging a try. It’s the easiest and most predictable way to invest on a consistent basis.
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