Dollar Cost Averaging (DCA)

Maintaining financial responsibility necessitates regular bill payments, encompassing necessities like housing, television services, water, and satellite radio. Nevertheless, a substantial number of individuals neglect applying this principle to their investment practices.

The harsh truth that they may eventually encounter is that consistent saving and investment are crucial for achieving financial objectives, such as financing major life events, acquiring a property, or ensuring a comfortable retirement. There are myriad opinions on the most effective wealth generation strategies, and one consistently advocated approach is Dollar Cost Averaging (DCA).

However, it is pivotal to acknowledge that systematic investment does not guarantee consistent market gains. Dollar-cost averaging is a strategy characterized by continuous investment in securities, irrespective of their fluctuating price levels. It necessitates the investor’s financial capacity to persist in purchasing, even during periods of low price levels.

DCA Defined

Dollar-cost averaging is a strategic investment approach primarily employed in the acquisition of mutual funds, wherein predetermined amounts are invested at regular intervals. This disciplined, long-term strategy aims to leverage the benefits of compounding to amass a substantial sum over time. To illustrate, consider an example where $100 is invested in stocks every month from January 1998 to December 2007. The following table and subsequent explanation elucidate this process.

How It Works

In DCA, a fixed amount of money is invested regularly, irrespective of the share price. When share prices are low, the fixed amount buys more shares, and when prices are high, it buys fewer shares. Over time, this can result in a lower average cost per share compared to the average market price per share.

In the Given Example:

• The average price per share is calculated as the total sum of share prices over the period divided by the number of months, resulting in $14.25.

• The average cost per share is calculated by dividing the total amount invested ($1200) by the total number of shares bought (85.04), resulting in an average cost per share of $13.53.

DCA vs. Lump Sum Investing and Market Timing

Dollar-cost averaging stands in contrast to lump sum investing, where the entire amount is invested at once. Lump sum investing can potentially yield higher returns if invested at an opportune time when prices are low. However, timing the market consistently is a challenging task, even for seasoned professionals.

DCA offers a more disciplined and less risky approach, particularly advantageous during volatile market conditions. It enables investors to avoid the pitfalls of poor market timing and the emotional stress associated with sudden market fluctuations.

Other Long-Term Benefits of DCA

Another potential benefit of using DCA is that it ensures that your money purchases more shares when prices are low and fewer when prices are high. Over the long term, the result could be that the average cost you pay for the shares may be less than the average price. Assume you invest $50 per month in an investment for 12 months and every month the share price fluctuates a bit. You can see that your $600 total would have bought you 42.7 shares. The average price per share, as calculated by adding up the monthly prices and dividing by 12, would have been $14.25. However, the average cost that you would have actually paid, as calculated by dividing the total amount invested by the number of shares, would have been $14.05 per share. Over the years, this method could potentially save you a lot of money.

In addition, DCA can offer the psychological comfort of easing into the market gradually instead of plunging in all at once. Although DCA does not assure a profit or protect against a loss in declining markets, its systematic investing “habit” helps encourage a long-term perspective, which can be soothing for people who might otherwise avoid the short-term volatility of the riskier, but potentially more profitable, investments, such as equities.

And last, DCA may help you make savvy investment decisions if you stick with it. For example, if your investment rises by 10%, you will likely post big gains because of the shares you’ve accrued over time. And if it declines by the same amount, take comfort in knowing that your next investment will purchase more shares at a less expensive price – shares that may regain their value and even exceed the higher price in the future.

Regular Investing Makes Sense

While investing a lump sum at the most opportune time can potentially profit you more than if you dollar cost average your investment, defining “opportune” is difficult for even the most seasoned experts. As a long-term strategy, you may find DCA to be more appropriate to help potentially lower your average cost per share, and allow you to feel more comfortable during uncertain markets knowing that you made sound investment decisions. Keep in mind, however, that you should consider your ability to purchase over long periods of time and your willingness to purchase through periods of low price levels.

Conclusion

Dollar-cost averaging provides a structured approach to investing, promoting consistency and potentially reducing the average cost per share over time. While it may not outperform lump sum investing during bull markets, it offers a less risky and psychologically comforting strategy, encouraging a long-term investment perspective and helping investors navigate through uncertain market conditions with confidence. Ultimately, the choice between DCA, lump sum investing, or other strategies depends on the individual’s financial situation, risk tolerance, and investment goals.

¹Source: Standard & Poor’s. Stocks are represented by the S&P 500.

²Richard E. Williams and Peter W. Bacon, “Lump Sum Beats Dollar Cost Averaging,” Journal of Financial Planning, April 1993, pp. 64-67.

Read What Other Bloggers Are Saying about Dollar Cost Averaging:

Dividend Growth Investor: Dollar Cost Averaging

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Cash Money Life: Pros and Cons of Dollar Cost Averaging