Feb 22, 2024
What is Dollar-Cost Averaging (DCA)? A Simple Definition
Dollar cost averaging (DCA) is a strategy that can help long-term investors build wealth over many years. Rather than trying to time the market with a lump sum of money and guess the best time to invest, you invest a smaller amount on a regular schedule, such as monthly or bi-weekly.
This allows you to buy more shares of a security when it has a lower price and fewer shares when it has a higher price. By investing the same dollar amount consistently through different time periods, you don’t have to closely follow investment prices in the near term.
You just invest when it’s time and let the market do its thing.
In this article, we will cover:
- How dollar cost averaging works
- The benefits of DCA
- The downsides of DCA
- Who dollar cost averaging is best for
- How to choose an investment schedule
DCA is also known as a “constant dollar plan”; you may see both terms used online interchangeably.
How dollar-cost averaging works
The idea behind dollar-cost averaging is simple: you choose a set amount of money to invest at regular intervals over time, such as monthly, bi-weekly, weekly, or even daily. Many people simply set up a recurring transfer from their checking account to their 401(k), IRA, or brokerage account.
The key is investing the same dollar amount consistently, without worrying about stock price fluctuations. When prices are high, your money will be buying fewer shares. But when prices dip low, the same investment amount will purchase more shares.
By investing evenly over time, you avoid trying to “time the market” and predict short-term price movements. This steady, systematic approach ensures you’ll buy at an average cost per share over months and years.
Stock market volatility becomes less of a concern because as long as the overall market rises in the long run, your portfolio value will too. This makes DCA a great strategy for new investors, hands-off investors and long-term investors.
An easy example of dollar cost averaging
Let’s say you have $2,400 to invest in a mutual fund or stocks. Instead of investing the full $2,400 upfront, you decide to dollar-cost average by investing $200 each month for 12 months.
In January, it costs $50 for one share. You invest $200 and get four shares. In February, the price drops to $40 per share, so your $200 buys you five shares. In March, the price drops even lower to $20 per share, meaning you can buy 10 shares with that month’s $200 investment.
This pattern continues over the year as the share price fluctuates up and down each month. The number of shares you purchase might look like this depending on the following prices:
|Number of shares purchased
By consistently investing $200 on a fixed schedule, you end up purchasing more shares when the price is low and fewer when it is high.
In the end, your total investment is still $2,400, but by using DCA you were able to accumulate more shares at below average cost compared to investing it all upfront in a lump sum.
- With lump sum investing, your average price per share is $50 (because you purchased all at once on January 1st) and you end up with 48 shares.
- With dollar cost averaging, you have a lower average price of $34.58 with 86 shares in total.
This hypothetical investment example demonstrates the core benefit of DCA—buying at different price points to reduce risk.
Over time, DCA can help lower the average amount of money invested for a given asset. It can also help you take advantage of market price movements without having to closely follow the price of a security or guess the best time to invest.
Dollar cost averaging vs. lump sum investing
Anytime you hear about DCA, you often hear about lump sum investing, too. So what’s the difference? The main difference comes down to timing.
With DCA, you invest an equal amount at regular intervals over a period of time. This allows you to buy at different price points through micro-investing. Lump sum investing means putting your entire amount into the market all at once.
Lump sum does not necessarily mean timing the market. Timing the market refers to making investment decisions based on trying to predict upcoming market movements. For example, waiting to invest because you think the market is about to drop. With a lump sum, you’re investing the total amount immediately regardless of market conditions.
The potential advantage of a lump sum is that your money starts working for you right away. But it also exposes you to short-term volatility risk. DCA helps mitigate this by spreading investments out, though it can miss out on greater gains if the market rises steadily.
DCA or lump-sum investing: Which strategy should you use?
When you have a large sum to invest, you may wonder: should I dollar cost average or invest it all at once? Remember, there is no “perfect” investment strategy. Figure out how much you should invest and design a plan that suits your situation and risk tolerance.
Keep in mind, you don’t have to choose just one approach. If you’re itching to get started now, consider a hybrid strategy called “front loading.” This involves investing a large chunk upfront, perhaps 50% to 75% of the total amount, then dollar cost averaging the remainder.
For example, if you have $20,000 to invest, you could put $10,000 into the market now as a lump sum, then invest $2,000 per month over the next five months. The initial lump sum gets your money working right away, while regular investments let you continuously buy at different price points.
Benefits of a dollar cost averaging
If you feel uneasy about investing large sums at once, DCA gives you a way to get started investing now without worrying about short-term fluctuations. Automating regular contributions also removes the emotion from purchase decisions.
Key benefits of dollar cost averaging:
- Mitigates the investment risk associated with market mistiming
- Reduces the impact of share price volatility by diversifying the price per share
- Makes investing more straightforward with a fixed, automated investment schedule
- Allows you to start investing sooner with a fixed amount that fits your current budget
- Alleviates the stress that market fluctuations can cause
- Focuses on building wealth over the long term
Disadvantages of dollar cost averaging
No investment strategy is perfect. While DCA helps reduce risk and stress, it also means holding some of your money outside the market in the short term rather than investing a lump sum. This “cash drag” could cause you to miss out on potential gains if the market rises quickly.
Studies show the benefits of DCA generally outweigh these potential downsides when used as part of a diversified, long-term strategy. And for many investors, the risks of attempting to time the market or panicking over short-term price movements pose a greater threat to returns.
Key downsides of dollar cost averaging:
- You may miss out on stock market returns if you hold onto cash instead of investing it
- You might not be able to invest in higher-price-per-share securities if your brokerage doesn’t offer fractional shares
- Some argue that DCA may simply defer risk rather than reducing it
- It may provide lower average returns in the short term than lump sum investing
- There’s no guarantee you’ll buy at the absolute lowest price
Who is dollar cost averaging for?
Dollar cost averaging may not be right for every investor. Those with high risk tolerance or seeking active online trading and short-term gains may prefer other strategies. But for many, DCA offers an accessible way to start investing for long-term goals.
You might want to consider DCA if you fit into any of these categories:
All investing involves risk, and it’s natural for people to worry about losing money. If the idea of investing makes you nervous, you may be tempted to hold off until you feel the timing is just right, especially during a declining market or potential recession.
But sitting on your cash means you could miss out on the gains you could have made by investing. And on the flip side, selling off assets in a panic if the market dips means you lose the opportunity for your investments to regain value when the market eventually rises again.
DCA removes the stress of trying to time the market. Panicky investors may find that a fixed, automated investment schedule helps them remove the emotion from investing that could destroy your portfolio’s returns. And they might feel more confident riding out market ups and downs knowing that the average cost of shares tends to be smoothed out by DCA, even when share prices are volatile.
Investors with less money to invest
If investing seems out of reach because you don’t have a large lump sum to start with, DCA can make it more accessible to get started. If you’re saving for retirement, for example, there’s no IRS-mandated minimum for contributing to an IRA or standard 401(k). And if you want to invest in individual stocks or funds through a brokerage, many offer fractional shares that allow you to put your money to work without having to purchase a full share of a specific security.
Plus, the regular investment schedule of a DCA investing strategy ensures that investors with less money stay invested even during a bear market, which can mitigate the risk of missing future growth.
If you’re just starting out, it can be overwhelming to learn the ins and outs of the market and develop an investing strategy. DCA saves you the stress and risk of attempting to figure out the right time to invest.
Plus, the practice of investing on a regular cadence can help you build healthy investing and saving habits. Dollar cost averaging can be a smart way to dip your toe into investing while you gain confidence and learn about additional strategies that may fit your investment profile.
“Set it and forget it” investors
While some people are eager to research investment strategies, watch market performance closely, and actively manage their portfolios, it can become quite time-consuming. For those who prefer a more passive investing approach, DCA can be a relief.
You just need to determine your budget and schedule, then set up regular automatic deposits into the investment account of your choice. Dollar cost averaging keeps you in the market consistently with little management required.
How to choose an investment schedule for dollar cost averaging
When implementing dollar cost averaging, one key decision is choosing how often to invest— aka, your investment schedule. A good place to start is aligning with your pay schedule.
If you get paid biweekly, contribute to your investment account biweekly. If you receive a monthly paycheck, invest monthly. This takes less of the investor’s effort because you can seamlessly transfer a portion of each paycheck into your investments without needing to manually contribute.
Beyond pay periods, consider your financial goals and time horizon. Choose a schedule you can stick to long-term that steadily builds your account over time.
5 tips for using a dollar cost averaging strategy
If you’re interested in using DCA as an investment strategy, use these tips:
- Automate your investments. Set up automatic monthly or quarterly transfers from your bank account to your investment account to avoid emotional decision making.
- Focus on low-cost funds. DCA works best when invested in broader market securities like ETFs, index funds or mutual funds to further spread out risk.
- Stick to your plan. Resist the urge to stop or change your contributions based on short-term market movements. Stay focused on your long-term goals.
- Rebalance periodically. As your portfolio changes in value, rebalance back to your target allocations to maintain proper diversification.
- Review your strategy annually. Make sure your DCA plan still aligns with your time horizon, risk tolerance, and other financial circumstances.
Invest regularly with Stash
The benefits of dollar cost averaging can support a buy-and-hold investing strategy that’s focused on your long-term financial goals. Maintaining a regular investing schedule could help you mitigate the risk of mistiming the market, diversify the average cost of shares over time, and reduce the potential stress of investing. It’s a fundamental part of the Stash Way, our investment philosophy based on investing regularly in a diverse portfolio for the long term.
With Stash, you can get started with any amount of money and have access to a wide range of stocks and funds with fractional shares. And Auto-Stash makes it easy to stick to your DCA goals with automated investing on the schedule that works for you.
Frequently asked questions about dollar cost averaging
Is DCA the best way to invest?
DCA may be the best strategy for panicky investors who worry about losing money or can’t invest a large lump sum initially. It also works well for beginners just starting to build wealth for retirement through a workplace retirement plan. Also, “set it and forget it” investors seeking lower-maintenance portfolio management can benefit from DCA’s disciplined approach.
Is dollar-cost averaging a good idea?
Financial advisors often recommend the use of DCA as part of a diversified portfolio especially during uncertain markets. While you may face higher transaction costs if you’re not using a fee-free brokerage account, using such strategies like DCA can be better if you’re risk adverse or want to build the habit of investing consistently.
How to do dollar-cost averaging?
In recent years, a robo advisor has become one way to easily implement a DCA strategy. You tell it how much from each paycheck and it handles automated purchases of low-cost index funds based on your risk tolerance. Or, you can manually schedule regular purchases of funds or company stock using a taxable brokerage account or IRA.
Why is it called dollar cost averaging?
The term “dollar cost averaging” was popularized by Benjamin Graham when he wrote about it in his book, The Intelligent Investor. It’s called “dollar cost averaging” because you spread your money out over time without trying to get the best price of the investment, thus “averaging” it over time.
How long should you do dollar-cost averaging?
There is no set rule for how long to dollar-cost average. The ideal duration depends on your goals and circumstances. For ongoing contributions like 401k investments, DCA can continue throughout your accumulation phase leading up to retirement.
The key is consistency—sticking to regular intervals over the long run lets dollar-cost averaging work its magic. Avoid stopping after arbitrary time periods or market fluctuations. Stay the course to smooth out volatility and take advantage of varying prices. DCA is meant to be a lifelong strategy, not a short-term tactic.
How do you calculate dollar-cost averaging?
You can calculate your average cost per share using a formula called the harmonic mean. The harmonic mean helps account for varying quantities purchased at different prices. The lower the average purchase price, the better.
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