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Dollar Cost Averaging Explained - Definition and Calculation
Did you know that you can enter the market even if you don't have a lot of money to invest? Dollar cost averaging is an investing technique that can help you do just that.
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What is dollar cost averaging or DCA?
Dollar cost averaging, sometimes also called DCA, is an investing strategy that can help to minimize risk. Let's say you're thinking about investing in a particular stock, ETF, or mutual fund, the first thing you need to figure out is when to invest. If you invest everything at once, you have to worry about timing the market perfectly, so you can get the best price, which has always been difficult to do. With dollar cost averaging, decide on the amount you want to invest over time, regardless of the share price. It's a way to help decrease the risk of paying up too much before the market drops. A benefit of this strategy is that you don't have to worry about timing the market at all – you're simply banking on the fact that you may pay a lower average price over time.
How does dollar cost averaging work? Formula and calculation
The aim of dollar cost averaging is to reduce the impact of volatility – the rate at which the price of a security increases or decreases. When the price goes up, you get fewer shares for the same money and when the price goes down, you get more shares.
By making periodic investments, you're essentially trying to take advantage of the fluctuating share prices.
This strategy tends to work better in the long-term. That's because asset prices tend to rise over time. It isn't the best option for short-term investing as that would bring back the volatility you were trying to avoid in the first place.
Formula:
Average price paid per share = Total amount invested / Total number of shares owned
Example of dollar-cost averaging
If you make monthly investments over a 12-month period, you may end up with more shares to your name than if you just invested everything at once. Here's a hypothetical scenario of dollar cost averaging, investing $100 monthly:
Month |
Share Price |
Number of Shares Purchased |
January |
$10 |
10.00 |
February |
$9.4 |
10.64 |
March |
$11 |
9.09 |
April |
$10 |
10.00 |
May |
$9 |
11.11 |
June |
$7.5 |
13.33 |
July |
$8 |
12.50 |
August |
$10.7 |
9.35 |
September |
$10 |
10.00 |
October |
$9.7 |
10.31 |
November |
$9.5 |
10.53 |
December |
$10 |
10.00 |
Let's say you purchase $1200 worth of a certain stock at $10 per share in January. You would then own 120 shares. However, if you purchase $100 of the same stock every month for 12 months, your average price would be $9.46, and you would own 126.86 shares.
You can see that you would end up saving 54 cents a share if you spread out your investments over 12 months instead of investing everything at once.
It's a good idea to do your due diligence before investing, even if an investment looks attractive, nothing is ever guaranteed. Diversification is generally considered to be a safer way to invest.
Advantages and disadvantages of dollar cost averaging
Advantages
- Reduces risk: This strategy allows you to average out the cost of your investment. This can help to reduce the risk of buying a lump sum before a big market downturn.
- Great for smaller budgets: It gets you on the investing bandwagon. So, what if you're making smaller plays? You can still get a feel for the market.
- Can help you avoid bad timing: You don't have to worry about predicting market swings because you're investing at regular intervals.
- No more FOMO: You won't get swayed by the fear of missing out.
Disadvantages
- Higher transaction cost: Multiple purchases may result in higher transaction fees over time. In some cases, this may offset the gains accrued by the current assets in the portfolio.
- You don't get in early: The market tends to go up over time. Investing a lump sum earlier may do better than smaller amounts invested over a period of time.
- Not exiting on time: It's easy to fall into the trap of not doing enough research and blindly following dollar cost averaging. This may encourage you to continue buying more stock at a time when you should simply exit the position.
Putting dollar cost averaging into practice
Dividend Reinvestment Plans (DRIP) and Systematic Investment Plans (SIP) make it easy for you to be consistent in building your investment portfolio and can be a way for you to try out dollar cost averaging.
Your online brokerage may even be able to help you set up notifications for when certain stocks hit your target price point.
Making dollar cost averaging work for you
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Stay consistent: For dollar cost averaging to be effective, your investments should run like clockwork. Once you decide how often to invest, try to stick with it. However, you must continue to monitor the company's performance to ensure you are not putting in more money when it's time to exit.
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Don't give in to fear: Market down? No worries. Do your best to ignore the fluctuations – volatility isn't a huge factor anymore but again; you must have a robust exit strategy in place.
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Put in the time: You still have to do the work. Pick and choose your investments carefully and continue to tweak your strategy. Dollar cost averaging doesn't magically turn a bad investment into a good one.
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Pick a platform that works for you: You will be making regular transactions, which is why it's important to choose a trading platform that doesn't nullify your gains with fees
On a final note
If you like the idea of a slow and steady approach, dollar cost averaging may be worth looking into. If you decide to move forward with this strategy, remember to do your due diligence before investing your money.
FAQs
How can dollar cost averaging help your investments?
Dollar-cost averaging involves investing equal amounts of money at regular intervals regardless of a security’s price. It can reduce risks posed by market volatility. It’s particularly useful for passive investors that don’t have the time to constantly keep track of changes in market conditions to determine the perfect time to buy or sell. It can potentially work best when investing in index funds that include a diverse range of investments.
When doesn't dollar cost averaging work?
No investment strategy is fool proof. Dollar cost averaging works well when investing in securities whose price fluctuates up and down over time. However, it doesn’t work well for a short-term investing horizon. In addition, it also increases your exposure in the same investment, which means it can prevent you from diversifying your portfolio. If you use it to invest in an individual stock and the price of that stock consistently increases, you’ll end up buying fewer shares every time. And if the price of that stock continuously declines, you’ll keep acquiring more shares at a time when it may be better to sell.
No investment strategy can provide absolute protection from declining market prices. However, dollar cost averaging operates on the belief that while markets fluctuate up and down over the short term, market prices tend to increase over the long-term.
Using dollar cost averaging to invest in individual stocks without researching and monitoring a company’s performance can prove to be very risky. If that company’s stock or performance continues to decline, that could be a sign it’s time to stop investing and think about selling your shares. Hence, it's crucial to research the market when investing in stocks.
Why is dollar cost averaging considered important?
Dollar cost averaging is considered important because it can help reduce investment risk by spreading purchases over time and can help mitigate emotional investing by maintaining consistency. Thus, dollar cost averaging simplifies the investment process, especially for new investors.
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