As with any investment, the objective of dollar cost averaging is to buy low and sell high. However, this concept is in fact notably complex to execute in the real world—particularly with respect to stocks, which are sometimes extremely volatile and thus make it virtually impossible to predict the perfect time to buy or sell shares. Nevertheless, dollar cost averaging (DCA) is one specific tool that can help minimize the risk of buying too high. Let’s explore this concept further.

An overview of dollar cost averaging

Dollar cost averaging is a long-term investment strategy wherein you spread out your equity purchases (stocks, funds, etc.) over regular buying intervals and in roughly equal amounts—rather than as one lump-sum purchase.

For example, instead of purchasing $24,000 of Apple stock in one fell swoop, you’d buy $1,000 worth of Apple shares every month over a 24-month period.

How dollar cost averaging benefits investors

The objective of dollar cost averaging is to minimize risks associated with market volatility. Let’s assume you decide to invest $1,000 a month by purchasing shares of Apple. Fluctuating stock prices will push costs higher during some months—impacting your ability to buy so many shares—while the cost of Apple stock will fall in other months (meaning you can purchase additional shares with that same $1,000).

The theory here is that over time, your cost per share will likely compare quite favorably to a lump-sum purchase option wherein you aim to perfectly time the market to score the best price (which is, in fact, very unlikely); dollar cost averaging ultimately smooths your purchase price over time to help ensure you won’t dump all your money into the pot at the highest point.

Another advantage of dollar cost averaging is that it quells the emotional side of investing. As many investors often react strongly when their stock price drops significantly, they often bail out and miss out on potential rebounds the investment goes on to experience (a scenario particularly prevalent when a large amount of money is invested in a single trade via a lump-sum purchase). By continuing to buy additional shares with smaller sums of money over time, it’s much easier to stomach a poorly timed investment.

Finally, dollar cost averaging also helps establish good investing habits: fostering discipline and discouraging investors from spending money earmarked for specific investments.

Dollar cost averaging drawbacks

Some experts deem dollar cost averaging less effective in a bull market wherein prices continually rise. While correct in theory, this scenario rarely plays out in real life as stocks almost always remain volatile—even in rising markets. That said, markets do tend to rise in value over time; therefore, a lump-sum approach can provide a more significant return when markets gain steam. Then again, choosing a suitable investment is even more critical in this case to increase the likelihood of a successful lump-sum strategy.

Any investment strategy, including dollar cost averaging, is only as good as the investments one selects. Therefore, if you invest in a stock that goes on to disappointment you with a poor performance, a DCA strategy won’t magically transform your bad choice into a good one.

How to establish a dollar cost averaging plan

Executing a DCA strategy is simple, and you’re perhaps already doing so without even realizing it—particularly if you contribute to a workplace retirement plan such as a 401(k).

To illustrate, let’s assume you contribute to a 401(k) plan every pay period. As most of these plans typically invest in an exchange-traded fund (ETF) or mutual fund, each paycheck contribution buys you additional shares of the same.

As with any stock, the value of underlying funds will fluctuate over time; in some months, you’ll receive more shares of the fund or vice versa when prices rise. This exercise in systematic investing can help you smooth out the purchase price over time and, in turn, implement a dollar cost averaging strategy.

Other dollar cost averaging considerations

Because dollar cost averaging means you’ll execute trades on a more frequent basis, this strategy does add to overall trading costs. These fees fade to the background compared to the overall value of your portfolio over time, however, especially since brokerage firms are now charging less than ever to make trades under current conditions. Nevertheless, if you’re concerned about this, remember that no-load mutual funds are traded in the absence of commission fees and represent a viable investment choice for your dollar cost averaging strategy.

Regardless of the amount invested, dollar cost averaging shines through as a long-term strategy given the need to experience corresponding highs and lows to see actual value. Consequently, you’ll generally want to hold on to your investment for at least five years if you decide to go this route.

In sum: dollar cost averaging

As with any investment strategy, dollar cost averaging has both pros and cons and is therefore only suitable for a specific batch of investors. While DCA offers an excellent way to slowly build wealth for investment newbies—particularly those favoring a “set-it-and-forget-it” approach—experienced investors with a large appetite for risk and/or seeking the flexibility to move funds (especially in light of increased exposure) may need to look elsewhere for their ideal investment strategy.

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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.