Dollar-cost averaging: How it works + Benefits and risks

If you want to get started with investing, one of the best ways to start is with dollar-cost averaging. This is an investment strategy that spreads out stock purchases over several months or years in an attempt to reduce market risk.

Using DCA or another investment strategy can help you avoid some common pitfalls that come with investing. In fact, this strategy can remove a lot of the work of timing the market to buy equities at the best price, leaving you more time to focus on other things.

Let’s dive into what DCA is and how it works, as well as understand the risks and benefits of investing in it.

What is dollar-cost averaging?

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 stock market volatility.

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 or don’t want to invest in the short term. And it can reduce the chance that you invest all your money right before a large drop in the stock market.

You can use dollar-cost averaging as part of your retirement plan and automate your investment plan by choosing a percentage of your income to regularly invest in a pre-selected investment choice.

When might dollar-cost averaging be useful?

Dollar-cost averaging (DCA) could be considered by those who:

• Are new to investing: For individuals just starting out, DCA may offer a way to begin investing without the need to focus on market timing.

• Have long-term goals: Some investors may find DCA aligns with long-term objectives, such as retirement or education savings, as it allows for gradual investment over time.

• Prefer consistency: DCA could appeal to those who prefer a structured, consistent approach to investing, regardless of market fluctuations.

• Are concerned about market volatility: By investing the same amount regularly, DCA might help reduce the impact of short-term market movements, making it easier to maintain a steady course toward financial goals.

What is DCA investing?

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. 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.

For example, let’s say you have $200 that you want to invest at the end of every month into ABC stock.

ABC stock’s price in January is $100, and in February, it rises to $110. You would invest $200 into ABC stock in both January and February despite the price change.

This means that in January, you would be able to buy 2 shares of ABC stock, and in February, you would be able to purchase ~1.82 shares of ABC stock.

You would continue this same investment strategy every month, which would allow you to benefit from the market conditions when prices are low and still take advantage of investing when the price increases.

It’s also a way to avoid the emotional highs and lows that come with the volatility of the stock market, like with value investing. When the stock market falls, and there are lower prices, 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.

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.

There are many ways investors can apply dollar-cost averaging. One of the most common ways people use DCA is through their employers 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.

You can also use DCA in any IRA account or brokerage account like Public. Simply buy a set dollar amount each month of the same stocks or funds through the app. If the price is low, you’ll have more shares. But if the price of the stock you are buying is high, then you’ll buy smaller amounts of shares.

In addition to 401(k) plans, dollar-cost averaging can also be used in mutual funds, index funds, exchange-traded funds (ETFs), and some dividend reinvestment plans, where dividends work by automatically reinvesting the payouts to purchase more shares over time.

Here’s an example of how dollar-cost averaging works in an investment account, where a fixed amount is invested each month despite the fluctuating share prices.

Example of DCA investing

Let’s say you plan to invest $2,400 for the year into AC stock.

Using our previous example, this breaks down to $200 per month. After a year, you look back and see that you didn’t always buy the same number of shares each month, despite spending the same amount each month.

The initial price point would have bought you two units ($200/$100 = 2.0). But in the other months, the share price fluctuated. So you may have bought, say, 1.82 units in February, 2.02 units when the share price went to $110, 2.04 units in April, and so on.

At the end of the year, you will have purchased ~23.92 shares by the end of the year for an average share allocation 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.

How to invest using DCA investing?

If you want to invest using DCA investing, you’ll need an account with a brokerage like Public. With the Public.com app, you can invest in the same dollar amount of a particular stock or fund each month. You can also automatically reinvest your dividend earnings back into the stocks they came from, earning you more money over the long term.

Simply log in to the Public website, look up the stock you want to buy, indicate how much you want to buy, and then make your purchase. Its really that simple!

Dollar-cost averaging vs. Lump sum investing

So, are you better off dollar-cost averaging or lump-sum investing?

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.

If the lump-sum investment was made when the price of the stock or asset was at a low point, you could get a higher return than with a DCA investing strategy.

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. However, it’s impossible to predict stock market changes and when the market will be up or down.

With 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.

Benefits of DCA investing

One of the benefits of dollar-cost averaging is that you can potentially take advantage of falling share prices and potentially purchase more shares over time. Some of the other benefits include:

• Helps minimize the risk of investing everything before a big drop in the stock market
• 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 a bear market and bull market

Risks of DCA investing

Wherever there are benefits, there are also risks associated with any investment strategy. Some DCA strategy risks include:

• Potentially missing out on higher market gains than if you were to invest all at once
• Higher transaction fees
• General risks associated with investing in stocks

How dollar-cost averaging is applied in various situations?

Dollar-cost averaging is not limited to retirement accounts; its a flexible strategy that can be applied to various investment goals and situations. Below are some examples of how DCA might be used in different real-life scenarios:

Investment in volatile markets:

DCA is sometimes used when investing in assets with high price fluctuations, such as tech stocks or cryptocurrencies. Rather than focusing on market timing, this approach may help spread risk and manage emotional responses to price changes.

Saving for major life goals:

For long-term objectives, like saving for a home, education, or retirement, DCA could be a helpful approach. Regular contributions to accounts such as a 529 education savings plan or investments in low-risk ETFs for a home down payment may align with this strategy.

Reducing large lump-sum risks:

In cases where individuals receive a large sum of moneysuch as a bonus, inheritance, or tax refund DCA offers an option to gradually invest the amount over time, potentially reducing the risk of investing during a market peak.

Building a diversified portfolio:

DCA allows gradual investments across different asset types, including stocks, ETFs, bonds, cryptocurrencies, or real estate investment trusts (REITs). This approach might help investors avoid overcommitting to any single asset at one time and manage diversification over time.

Adapting to changing financial conditions:

As financial circumstances evolve, DCA provides flexibility in adjusting the investment amounts. Some might start with smaller monthly contributions during tighter budgets and increase them as income grows, which can help maintain an investment plan through lifes changes.

Start DCA investing with Public

When beginning your investment journey, a good investment strategy will help guide you through market timing, even when stocks are in a bear market or even investing during a recession. 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. With the Public.com app, you can use DCA strategy to determine your positions and plan for your financial future.