Table of Contents:
- Dollar-cost averaging definition
- What is DCA investing?
- How does DCA investing work?
- Benefits of dollar-cost average investing
- Risks of the dollar-cost averaging strategy
If you are new to investing, you may wonder where to get started and how to invest your funds for a long-term benefit. Investing for beginners is like walking into a new world of endless possibilities but also endless risks. The good thing is that having an investment strategy in place can help you avoid some common pitfalls that come with investing. Dollar-cost averaging is a great investment strategy to learn. So, what is DCA, and how can it benefit you in the long run? Let’s take a closer look!
- Dollar-cost averaging is an investment strategy where you invest the same amount of money into the same stock or funds over a long period of time despite the highs and lows of the market.
- The act of dollar-cost averaging consists of buying more shares of a stock when prices are low and buying fewer shares when prices are high. This can result in spending less on the average cost per share than you would if you were to purchase at one time with a large sum of money.
- An employer 401(k) plan is a common example of DCA.
- Lump-sum investing is when you invest a large sum of money at one time.
- By using dollar-cost averaging, you can potentially purchase more shares over time than you would if you were to invest all at once.
- Dollar-cost averaging can help reduce risk..
- With dollar-cost averaging, you can potentially miss out on higher market gains than if you were to invest all at once.
Dollar-cost averaging definition
Dollar-cost averaging is an investment strategy where you regularly invest the same amount of money into a particular stock or fund over a long period of time independent of the highs and lows of the market. The dollar-cost averaging is a great technique to use if you do not have a large sum of money initially to invest at one time. Investors may also look to DCA as a psychological way of investing to avoid the emotional highs and lows that come with the volatility of the stock market. When market prices drop, some investors may fear that this will impact their profit and rush to exit a position, which in the long run could result in a gain. On the contrary, when market prices rise, investors will look to enter the market to benefit from this potential high. However, there is no telling if the market will continue to trend in an upward direction. Timing the stock market is nearly impossible to predict and can cause more damage than good if you are not careful about how you allocate your funds. In addition, investing a large sum of money at one time can be daunting for anyone but especially a first-time investor. The act of dollar-cost averaging consists of buying more shares of a stock when prices are low, and buying fewer shares when prices are high. Over time this type of investment strategy can result in spending less on the average cost per share than you would if you were to purchase shares all at one time with a large sum of money.
When you think of the DCA meaning, you may wonder how this investment strategy differs from others. Depending on what your needs are as an investor, you may look to compare whether dollar-cost averaging or lump-sum investing is more beneficial to you. Whatever you decide, it’s essential to understand the difference between both strategies to consider both the benefits and risks.
What is DCA investing?
As previously mentioned, DCA investing is an investment technique of periodically investing a fixed amount of money into the same stock or mutual fund independent of the ups and downs of the market or price changes. For example, let’s say you have $200 that you want to invest at the end of every month into AC stock. AC stock’s price in January is $100, and in February, it rises to $110. You would invest $200 into AC stock in both January and February despite the price change. This means that in January, you would be able to buy 2 shares of AC stock, and in February, you would be able to purchase ~1.82 shares of AC stock. You would continue this same investment strategy every month, which would allow you to benefit from the market changes when prices are low and still take advantage of investing when the price increases.
Over time, your total shares purchased may be higher than if you were to purchase the shares at one time. Again, timing the market is nearly impossible, and because of this, it is difficult to predict what future prices may look like. If you were to purchase AC stock at one time with a large sum of money, there is no telling if you are benefiting from a great time to purchase the stock.
There are many ways investors can apply dollar-cost averaging. One of the most common ways people use DCA is through their employer 401(k) plans. A 401(k) plan gives an employee the ability to invest a percentage of their salary into mutual funds or target-date funds. When an employee receives their salary, a percentage of their salary is invested into their fund of choice through their 401(k). Since a 401(k) plan is meant to appreciate in value and ultimately benefit you in the long-term, this makes it a perfect option for dollar-cost averaging.
Dollar-cost averaging vs. lump sum investing
So the question is, are you better off dollar-cost averaging or lump-sum investing? It’s essential to first understand how the two differ from one another and what the opportunities and risks are for these investment strategies. Lump-sum investing is, as the name suggests, investing a sum of money in stock or a fund all at once. Whereas dollar-cost averaging is spreading out the investment of a sum of money by spending a constant fraction of the sum on a particular stock or fund at regular intervals.
Some investors may choose to take a lump-sum investing approach if they want to take advantage of investing a large amount of money as quickly as possible without waiting on market changes. Lump-sum investing can also result from an investor receiving an inheritance, benefiting from tax returns, or simply having a large amount of funds. If the market trends upward after investing a large sum of money, this will positively impact the investors’ profit. However, if the market trends downward after a large sum of money is invested, this would have the opposite effect. Although it is impossible to predict market changes and which investing strategy, in the long run, will result in more gains, the consensus is that lump-sum investing over time can yield a higher return. For this reason, having a lump sum of money to invest at one time can help you take advantage of market gains rather than waiting and potentially missing out.
Lump-sum investing can also come with risks, such as contributing to the emotional stress of investing a generous amount of money at one time, losing profits from downward market trends, and not having the ability to take advantage of lower share prices. On the contrary, when you use dollar cost averaging, you can potentially miss out on higher market gains you would get if you were to invest at one time. In addition, dollar-cost averaging can come with higher transaction fees, which can affect your returns. However, investing with DCA stock can minimize risks, can be used at any time because you do not have to have a lot of money to start investing, can contribute to less stress psychologically by investing small amounts over time, and allows you to take advantage of the highs and lows of market prices.
How does DCA investing work?
When understanding how stocks work, it is important to know that DCA investing is a strategy that focuses on the idea that stock prices will rise. This method allows you to strategically ride price fluctuations and reduce risks, which, over time, can increase your profit. When you use dollar cost averaging, you are able to purchase more shares when stock prices are low and fewer shares when prices are high. Dollar-cost averaging is not only a great way to steer clear of emotional investing, but also is a great way to manage your finances so that you are not using your investment budget for other lifestyle purchases.
Let’s take a look at the previous example and break it down further to understand the ins and outs of how dollar-cost averaging works.
Dollar-cost averaging example
You plan to invest $2,400 for the year into AC stock. Using our previous example, this breaks down to $200 per month. Let’s take a look at how this will play out in a year considering the below example.
|AC Share Price||# of Shares|
In this scenario, if you invested $200 each month into AC stock, you will have purchased ~23.92 shares by the end of the year for an average share price of $100.33. However, if you invested $2,400 at one time into AC stock during the month of February, you would have purchased ~21.82 shares or ~23.76 shares during the months of May, August, or December. By using the dollar cost average strategy in this scenario, your end-of-year share amount would be more than if you purchased in one lump sum during the months of February, May, August, or December.
In addition to 401(k) plans, dollar-cost averaging can also be used in no-load mutual funds, index funds, exchange-traded funds (ETFs), and some dividend reinvestment plans.
Benefits of dollar-cost average investing
Taking advantage of share prices and potentially purchasing more shares over time is a great benefit to consider. However, dollar-cost averaging comes with other benefits, such as it:
- Helps minimize risks.
- Allows you to invest with small amounts of money.
- Decreases psychological stress by spreading out your funds over time.
- Helps you take advantage of the highs and lows of the market.
Risks of the dollar-cost averaging strategy
Wherever there are benefits, there are also risks associated with any investment strategy. Some DCA strategy risks may include:
- Potentially missing out on higher market gains than if you were to invest all at once.
- Higher transaction fees.
- Risks associated with investing in stocks.
When beginning your investment journey, a good investment strategy will help guide you through the highs and lows of the market. The world of investing will always come with rewards and risks. However, it is important to choose a strategy that works for you as an investor. Dollar-cost averaging is a great investment strategy for beginners and for those who want to start investing despite their budget amount. Dollar-cost averaging gives you the freedom to invest with small amounts of money, and over time, it may help expand your finances. In addition, dollar-cost averaging can help you minimize risks and take the emotion out of investing.
DCA is a great way to financially plan for the future. Whatever strategy you choose, make sure you download the Public app today to take your first step toward investing.