Dollar-cost averaging explained
Understand how dollar-cost averaging works with examples and use cases
Key takeaways
An investment strategy where you invest a fixed amount of money on a regular basis, regardless of market price fluctuations.
By buying more shares when prices are low and fewer when prices are high, the dollar-cost averaging strategy can lower your average cost per share.
Dollar-cost averaging may be suitable for beginners, long-term investors, and those who want to reduce risk by avoiding market timing.
What is dollar-cost averaging?
Dollar-cost averaging (DCA) is an investment strategy with a fixed investment schedule regardless of the share price. In other words, dollar-cost averaging means investing the same amount of money at regular intervals over a certain period of time. DCA removes the uncertainty of market timing and enables investors to invest regularly. Additionally, investors can lower their average cost per share and minimize the impact of volatility on their portfolios.
In contrast, lump-sum investing is where you invest a large amount of money at one time. This gives your investments exposure to the market sooner and may result in immediate gains if the market is on the rise. The downside is there’s also the risk of entering the market at a high point and potentially facing losses. So, a dollar-cost averaging strategy is sometimes seen as a safer approach for risk-averse investors.
How does dollar-cost averaging work?
Dollar-cost averaging is a simple technique for building savings and financial wealth over the long term.
Dollar-cost averaging is often used in 401(k) plans, in which employees invest on a regular basis regardless of the investment price. They can choose the amount of money they wish to contribute and the investments offered by the plan. Every pay period the investments are made automatically. Depending on the markets, employees might make larger or smaller gains. DCA can also be used by making regular purchases of mutual or index funds.
The table below shows an example of dollar-cost averaging:
Investment timing | Amount | Share price | Purchased share |
Month 1 | $100 | $5 | 20 |
Month 2 | $100 | $5 | 20 |
Month 3 | $100 | $2 | 50 |
Month 4 | $100 | $4 | 25 |
Month 5 | $100 | $5 | 20 |
Total investment |
| Total purchased shares | |
$500 |
| 135 |
To calculate the average cost per share in this example, you divide the total investment by the number of shares bought: $500 ÷ 135 = $3.70 (rounded to the nearest cent). So this average cost shows what the investor actually paid overall, even though the share price fluctuated from $2 to $5. By spreading their investment steadily over the months, they ended up with more shares for the same amount of money.
With the dollar-cost averaging approach to investing, investors can take advantage of potential price declines that lower the average cost per share. This, in turn, makes it possible to purchase more shares.
Lump-sum investing, on the contrary, means that investing a fixed amount of money at one time. Taking the share prices from our example above, let’s say you invest $500 in the first month with an average cost per share of $5, to give a total of 100 shares. If you had waited until month three, when the price dropped to $2, you could have bought 250 shares with the same amount of money. The catch is, there’s no way to predict the best time to invest.
That’s why the DCA strategy can be valuable: by investing a fixed amount regularly over a long period, you increase your chances of buying when prices are low without trying to time the market.
Benefits and drawbacks of dollar-cost averaging
Besides the potential reduction of the costs per share, there are several other advantages of dollar-cost averaging:
It establishes the habit of investing regularly to build financial wealth over time. By setting up regular, automatic contributions, it’s unlikely you’ll miss the invested money, and you might develop a strong investing habit while also sticking to your plan.
You’re more likely to profit from opportunities. Market timing is important, but it’s almost impossible to predict when the market will reach its high or low and therefore when to buy or sell — even for professional investors. Dollar-cost averaging has the advantage that you’re less likely to miss opportunities.
It minimizes the drawbacks of market timing, such as buying only when prices have already risen or selling in a panic amid a market decline. Using the dollar-cost averaging technique, staying the course and rebalancing your portfolio can potentially generate larger gains.
It can take the emotions out of investing and prevent you from chasing stocks while they’re in high demand or from investment fads. It can happen that investors take more risk in their investment portfolio, become overconfident when markets are rising, and panic when the markets start to fall. That’s why the dollar-cost averaging strategy can even things out and help investors stick to a plan no matter what’s happening in the markets.
That said, dollar-cost averaging does have some drawbacks:
There’s no guarantee of profits or security against losses when the markets are in decline.
You might miss out on gains. If a stock or fund is rising and you didn’t invest a larger amount right away, you might miss out on potential profits.
- It can potentially lower returns. Compared to lump-sum investing, dollar-cost averaging may generate less profit over a longer period of time.
Balancing investments with cash reserves
Although dollar-cost averaging can promote consistent investing, it doesn’t mean investors have to put every available dollar into the market. Keeping some money in cash can also be a way to diversify your portfolio, and doesn’t come with the risks of investing. A solid cash reserve can act as a financial cushion or emergency fund for any unexpected costs that come your way.
With Raisin, you can make your cash work harder by comparing competitive savings rates from a wide range of partner banks. With a high-yield savings account, for example, your uninvested money can also earn interest while remaining accessible when you need it.
Types of investors that might use DCA
Generally speaking, dollar-cost averaging can be used by any investor who prefers automatic investing over regular intervals of time and not having to make purchase decisions under pressure. However, if prices are trending steadily in one direction or the other over the investment period, the DCA strategy might not be a good fit. Long-term, risk-averse, and beginner investors might first consider the outlook for an investment and the broader market when deciding whether to use dollar-cost averaging investing.
Beginner investors: Dollar-cost averaging might be useful for beginner investors without the experience or expertise to decide when to buy or sell.
Long-term investors: If you don’t have the time or desire to watch the market and time your orders, dollar-cost averaging might be a good opportunity for regular and long-term investments.
Risk-averse investors: DCA can help to lower the risk of buying at high-priced markets by spreading investments over time.
It’s important to remember that there’s no such thing as a “risk-free” investment. With investing, there is never a guarantee you will get back your principal.
How to get started with dollar-cost averaging
- Open an investment account with a brokerage or investment platform that offers the assets you’re interested in.
- Pick an investment amount that fits your budget comfortably without causing financial strain.
- Decide how often you want to invest (monthly is a common choice).
- Select the assets you want to invest in, such as individual stocks, ETFs, mutual funds, or other options.
- Arrange for automatic contributions to be made regularly to your investment account.
Start building your savings with Raisin
While Raisin doesn’t offer dollar-cost averaging investment plans, you can complement any investment strategy with the steady growth offered by high-yield savings accounts. Since interest rates can change from time to time, you can easily make changes to your savings as needed.
If you prefer the certainty of a fixed rate and don’t need to add money regularly, certificates of deposit (CDs) offer competitive rates for locking in your savings for a set period. Raisin’s marketplace makes it easy to compare top rates on a variety of savings options from trusted banks and credit unions. Take a look and get started today!
The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.
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