What is Dollar Cost Averaging?
Dollar Cost Averaging or DCA is the technique of buying a fixed dollar amount of an investment on a regular schedule, irrespective of the price. The theory being that more shares are purchased when the price is low and fewer shares purchased when the price is high.
The most common examples of this are your 401k and 403b investment plans through your employer. Every paycheck you have a set amount set aside to purchase a predetermined investment at whatever price is currently being offered.
The most common vehicles for the use of this type of investment are mutual funds or ETF(exchange traded funds). Typically these are the choices offered in most employer retirement plans. The best option to look for in mutual funds is a no-load fund.
This means that there are no fees upfront for investing in the fund. In some cases, you can start with as little as $25 to invest. Which is great for folks just starting out or on a limited budget.
Some mutual funds will waive their minimums if you start an automatic investment plan. These are often available directly through the mutual funds website.
ETFs are also great for this strategy as well because of their no minimums to invest and typically ultra low fees they charge.
The idea behind all this is to try to give people the opportunity to take advantage of the power of compounding, which we discussed earlier.
5 Pros of Dollar Cost Averaging
- Potentially lowers your risk with each investment. So how does this strategy lower your risk? The strategy evens out your investment through time. As each time, you buy the price will be different. Which will average out the price and potentially lower the risk of buying too high or too low? An example would be:
Dollar Cost Averaging Example
This would be a classic example of how dollar cost averaging works. As you can see it helps smooth out your investment to make it potentially more profitable. Here is a link to a dollar cost averaging calculator to help you see how this could be beneficial to you.
- It helps reduce the effect of emotions on our investing strategy. By using a mechanical investment vehicle like dollar cost averaging you are taking the emotions out of the equation. In theory of course. By utilizing this way of investing it eliminates the freaking out when the market is going down. And likewise, when it is going up.
- It avoids market timing. This is one of the big ones as almost no one can predict which way the market will go any given day. Even the most famous investors admit they have almost no way to predict which way it will at any time. The key is to have conviction with your investments and to trust your judgement.
- It helps avoid the large lump sum investment and bad market timing. Let’s say you came into a large sum of money from an inheritance or a big bonus at work. The initial thought would be to put the whole lump sum into an investment. So if you but all of your $10,000 into an investment and the market suddenly took a turn for the worse. Which means you would be losing more money than if you had just invested some.
- It’s psychology. It makes you feel better that your investments are in theory safer or there is less risk involved. By utilizing dollar cost averaging it helps some people stay invested in the market and be able to sleep at night.
2 Cons of Dollar Cost Averaging
- The stock market rises over time. One disadvantage of dollar cost averaging is that the market tends to go up over time. This means that if you invest a larger sum in the market earlier. It is very likely to do better over time than a smaller investment. The larger sum will produce a better return over time as the market continues to rise.
- It is not a good substitute for finding good investments. Dollar cost averaging is not the end all be all of investing. You still need to do your research and identify good investments. Because if you invest in a bad pick you will be steadily investing in an investment that will continue to lose money. It also does not allow for adapting to the environment in the market. Let’s say you uncover a pick that has potential based on news that its earnings will allow it to increase its value. Your strategy will not allow you getting into an investment with that particular company.
As you can see dollar cost averaging has some particular strengths that will appeal to certain investors. It also has some weaknesses that will not appeal to other investors.
It can be a tool that you can use in your strategy to invest for your future. If you are the type that stresses about every pick that you make in the market this could be a strategy that will help you sleep at night.
Also, it can help you stay invested as it can discourage any anxiety you may have about the ups and downs of the market. And there will be ups and downs. But this strategy can help smooth out the emotions and keep you investing which it ultimately the most important thing.