- Dollar-cost averaging (DCA) is a game-changing strategy employed by investors to reduce the impact of volatility
- It is the process of investing small amounts of money incrementally at regular intervals, as opposed to investing a lump sum of money at once
- The method is intended to get the average price rather than trying to time the market
- It helps investors stay focussed on their strategy by removing the burden of emotions that come with investing in a volatile market
Is dollar-cost averaging up a good idea?
In many ways, dollar-cost averaging is an important strategy for long-term investors and helps to remove the emotional barriers to investing, especially during volatile times. It therefore prevents individual investors from making harmful decisions out of greed or fear, such as buying more when prices are rising or panic-selling when prices decline. DCA shifts the focus more to contributing a set amount of money each month, regardless of price.
Since offloading a lump sum of money runs the risk of purchasing when the market is at its peak, dollar-cost averaging also removes the burden of trying to time the market and potentially losing money. Let’s say you invest money just before a big market downturn. You would have ended up losing more money than if you had invested only some of your money before the downturn.
It also means that if your investment does turn out to be a bad pick, then the fact that you didn’t put a lump sum in all at once means you can withdraw from that investment after investing, for example, $200 over 2 months rather than $1,000 in one!
What is Wrong with Dollar-Cost averaging?
Dollar-cost averaging only allows investors to build wealth if the asset prices increase during the period of time in question. Therefore, it only works if the investment price increases and cannot protect individual investors from risk and plummeting prices when they arise. It’s therefore worth keeping an eye on the company’s performance because you may continue buying stock at a time when it makes more sense to exit the investment altogether.
It's also important to note that dollar-cost averaging is not guaranteed to protect your investments from volatility, and risks remain a key characteristic of investing regardless. It pays to keep on track of company records and good investments. However, if you want to mitigate the potential of declining stock prices, then less-experienced investors could opt to invest in index funds rather than individual stocks.
Dollar-Cost Averaging Example
So you have $600, and you decide to contribute $200 into your investment per month. In one month, you might find that your specific investment is trading at $10 per share, meaning you’d be able to purchase 20 shares that month. However, the next month you find that your chosen investment is trading at $50 per share, meaning you’re only able to purchase 4 shares that month. By the third month, the market takes a tumble and the price plummets to $5 per share, putting another 40 shares into your investments that month. Therefore, over a three-month period, you'd invest $600 in 64 shares.
In this example, even with price fluctuations over the three months, at $600 invested with 64 shares, your average cost per share is $9.37 ($600 ÷ 64 = $9.37).
If you decide to sell in month four at $10 a share, you would make $640, and therefore profit $40. However, if you were to then sell in month five when they’re going for a $20 per share price, then you’ll find that you would have made $1,280, meaning you would have generated $680.