What is Dollar-cost Averaging (DCA)?

Dollar-cost averaging is like eating a pie in slices instead of all at once…

You bake a pie and want to eat it, but if you eat the whole thing at once, you might get a stomach ache. Instead, you decide to slice the pie into six equal-sized slices. You eat one slice each day for six days, and that reduces your risk of a stomach ache. Similarly, dollar-cost averaging slices your investment into multiple smaller purchases to try to reduce the risk of volatility.

Dollar-cost averaging, or DCA, is a strategy for investing money in the market. It relies on making relatively small purchases at regular intervals instead of in one lump sum.

For example, someone who comes into a $120,000 inheritance could put all the money into the market immediately, purchasing $120,000 worth of shares - but he or she could instead decide to dollar-cost average, making 12 monthly purchases of $10,000 each over the next year.

Dollar-cost averaging limits an investor’s risk and volatility. It can help reduce losses - if a security’s price falls after an investor makes a big lump-sum investment, the investor would lose a lot of money. Dollar-cost averaging limits that. However, it can also reduce gains, if a stock is rising in value but the investor is holding onto cash for future purchases instead of investing his or her full balance immediately.

DCA investing is also useful for beginners and those who don’t have large sums of money. Instead of waiting to build up a large balance, investors can use dollar-cost averaging, investing small amounts over time.

One way someone can dollar-cost average is by breaking a lump sum of money that he or she wants to invest into multiple, equal portions to be invested over time. For example, an investor could break $24,000 into six portions of $4,000 each and make six $4,000 stock purchases over the next six months.

Another way is to use regular income to make regular purchases. Many people have retirement plans, such as 401(k) accounts through their employers. If someone has his or her employer deduct money from each paycheck to invest in a 401(k), that person is dollar-cost averaging.

Over time, by making equal purchases, an investor using dollar-cost averaging will tend to buy more shares at a lower price and fewer shares at a higher price.

Consider someone who invests $100 per month in a company with a share price that fluctuates between $10 and $20. In the first month, a share costs $10, so the investor will buy ten shares. The following month, a share costs $20, so the investor buys just five shares. The month after, a share is worth $12.50, so the investor buys eight shares. After three months, the investor owns 23 shares, almost half of which were purchased at $10.

By managing the number of shares purchased at a low cost as well as the number of shares bought at higher prices, some investors believe they can increase their return on investment and reduce their risk.

To calculate the average cost of a share under dollar-cost averaging, you don’t need to know the value of each share at the time the investor purchased it. You only need to know the total amount of money the investor spent and the total number of shares purchased.

The formula to calculate the average cost is:

Amount invested / Number of shares purchased = Average cost per share

For example, if an investor made 12 purchases of shares of a mutual fund, each totaling $1,000, that investor spent a total of $12,000. If the investor purchased a total of 500 shares with his or her $12,000 investment, the average cost per share would be:

$12,000 / 500 = $24

There are two scenarios where dollar-cost averaging may make sense.

One is when you don’t have a large sum of cash to invest, but still want to make regular investments. You can set up an automatic investing plan, to have your employer deduct money from each paycheck to make regular purchases in your 401(k) account.

Another situation in which to use dollar-cost averaging is when you have relatively low tolerance for risk. Some investors fear sinking a lot of money into the market at once, because of the risk that their investment could quickly lose value. By making smaller, regular purchases, you can reduce your losses from any single drop in a stock’s price.

On the downside, if the stock you’re buying jumps in price, you’ll miss out on potential gains because you didn’t put all of your money into it right away.

One benefit of dollar-cost averaging is that it makes investing less emotional. Investing can be risky, even if you’re buying more conservative stocks and bonds. You could lose some or all of the money you invest. Fear of those potential losses can make an investor reluctant to make large investments.

Deciding to dollar-cost average can help reduce that fear because you don’t have to decide when it’s the right time to invest. Instead, you follow a set schedule. It imposes discipline on your investing, and makes it easier - you can set up a plan to invest money automatically each month, and forget about it.

Dollar-cost averaging also helps reduce the urge to time the market, to invest at the time you think a stock or bond is at a low price. Market timing can increase your overall returns, but it is incredibly difficult to do effectively, and most investors who try to beat the market’s performance aren’t able to do so.

Dollar-cost averaging is also an effective strategy for people who don’t have a lot of money set aside to invest. They can start with small amounts, deducted from their income, and make frequent additions.

Dollar-cost averaging can be a good idea if you want to invest a lot but don’t have cash saved to do so. Making regular investments from your stream of income can be a good way to start building a portfolio.

However, if you have money already set aside, putting it into the market as a lump sum could perform better than dollar-cost averaging over the long term. Between 1926 and 2011, lump-sum investing produced stronger returns than dollar-cost averaging did in 67% of those ten-year periods, according to a study by the Vanguard mutual-fund group.

But past performance doesn’t guarantee future results, and those numbers don’t account for each individual’s different tolerance for risk. It can be scary to make a single large lump-sum investment - essentially putting all your eggs in one basket and knowing that the shares you bought could suddenly drop in price. Making smaller purchases can help reduce that fear and help an investor stick to their investing plan. History has shown many people panic during a downturn and sell their holdings and thus they don’t participate when the market ultimately recovers.

The bottom line is that there is no single answer as to which strategy is right for you. The answer depends on your investing goals, your risk tolerance, and how you plan to fund your investment purchases.

Dollar-cost averaging does not guarantee positive investing results, nor prevent losses in down markets.