What is dollar cost averaging (DCA)?
Dollar cost averaging (DCA) typically involves investing the same dollar amount at the same interval in the same investment vehicle.
A common example of DCA includes making contributions to retirement accounts, such as a 401k or an IRA.
When considering whether DCA is right for you, it can be helpful to understand potential fees and compare it with other investment options, such as lump sum investing.
Understanding dollar cost averaging
The definition of dollar cost averaging:
Dollar cost averaging (DCA) is the practice of regularly investing a set dollar amount at a set time into an investment, regardless of the market price.
How dollar cost averaging works
With DCA, an investor generally selects a specific dollar amount to invest over regular intervals of time. They typically choose the same investment vehicle or tool, such as a certain stock or a retirement fund. The investor generally continues to invest that same amount of money in the same investment, no matter what the price of that investment is doing.
Exploring various investment options, such as dollar cost averaging, can be one piece of building an investment portfolio. Holding short-term cash in a high-yield savings account until you’re ready to invest can be part of a diversified portfolio, and Raisin will help you compare competitive rates in one place.
The benefits of a dollar cost averaging strategy
Managing volatility
Investing inherently comes with risks since market prices can fluctuate. DCA may help manage volatility because it typically means purchasing smaller amounts of shares over a longer period of time. It may also help reduce the chance of making investment decisions based on emotions.
Building disciplined habits
DCA may help investors build the habit of making regular investments. Automatic contributions, such as with a retirement account, may further help build investing habits for some people.
Dollar cost averaging vs. lump sum investing
Lump sum investing generally involves investing a set amount of money all at once, rather than spreading the investment dollars out over time.
When to use each
Lump sum investing may be an option for investors looking for long-term investment options. It may also be an option for investors who have some tolerance for market volatility. DCA may be an option for investors who have less risk tolerance or for investors who may be newer to investments.
The cost of waiting
Because market prices may fluctuate, it could be possible that share prices of an investment increase over time. Because DCA often involves investing regular amounts of money over time, it could lead to an investor purchasing fewer shares if the price increases. This situation could mean the investor might miss out on some potential gains.
How to start dollar cost averaging
Choose an investment:
Investors interested in DCA may want to first start by choosing the type of investment they prefer. Investment options may include stocks, exchange traded funds (ETFs), or mutual funds.
Determine frequency:
It can be helpful to choose a frequency that aligns with your financial goals, which might be weekly, bi-weekly, or monthly investments.
Automate the process:
It may be helpful to automate the investments. Recurring transfers can take the manual work out of remembering to invest at set times.
Common examples of DCA in daily life
Retirement accounts: 401(k)/IRA
One common example of DCA could be retirement accounts, such as 401(k)s or IRAs. An individual with a retirement account may choose a dollar amount or a percentage of their monthly pay to be automatically invested into their retirement account at regular intervals, such as once per month.
Dividend reinvestment plans (DRIPs)
Some investors might choose to use DCA to invest in stocks that may pay dividends, or ETFs that may bring in additional income. Potential dividends from the stock or the potential income from the ETF may be used to automatically purchase more shares.
Potential drawbacks to consider
Transaction fees
There may be transaction fees associated with DCA. Investors frequently buying shares may experience more brokerage costs as well, depending on the platform being used.
Lower returns in bull markets
Investing a lump sum during a steadily rising market may lead to more gains than opting for DCA, though it is not guaranteed. Lump sum investing may allow an investor to buy more shares of a stock sooner than might be possible with DCA. If that is the case, the lump sum investment option could potentially lead to more gains if the stock price rises, though again, there is no guarantee.
Bottom line
Dollar cost averaging might be an investment tool to add to your portfolio. Investors who may be less risk tolerant or who may be newer to investing could explore DCA to see if it’s a fit for their financial goals.
If you’re looking at ways to maximize your savings potential, the Raisin platform can help. It offers a comparison of high-yield savings products all in one place to help you reach your goals, whether you’re saving up for a home or planning to invest.
Frequently asked questions
Timing the market is notoriously difficult because it relies on predicting short-term price movements, which can be inconsistent even for professionals. DCA offers a more disciplined alternative by focusing on consistent, regular investments. This approach removes the pressure of trying to "guess" the market's bottom and prioritizes time in the market over timing the market.
DCA involves investing set amounts of money in an investment at set times, which may help an investor reduce exposure to volatility. It does not, however, guarantee a profit or protect against loss in a declining market.
Each platform will have different criteria. Some platforms may not have a minimum dollar amount.
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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