Personal Finance Essentials
The Best Investment Approach of All: Dollar Cost Averaging
A Powerful Investment Strategy That Transforms
Market Volatility from a Threat to an Opportunity
Dollar cost averaging (DCA) is a powerful investment strategy that transforms market volatility from a threat into an opportunity. Instead of trying to figure out the best time to invest, DCA has you simply invest a fixed amount of money at regular intervals, regardless of market conditions.
How It Works
Say you invest $100 monthly into a diversified stock fund, and the share price in the first month is $5. In the second month, the price is $10.
What is the average price? If you said $7.50, that’s because you split the difference between $10 and $5. But that’s wrong. When you invested $100 at $5 per share, you bought 20 shares. When the price was $10, you bought 10 shares. You own 30 shares – and since you invested a total of $200, you paid an average of $6.67 for them, not $7.50.
This is why dollar cost averaging is successful: when you buy consistently, you get the average low price for your shares over time. And since you’re getting the average low price, that suggests you’ll end up with a profit.
Dollar cost averaging removes the emotional baggage that prevents people from investing. You don’t have to fear that you’re investing at a market peak – because if prices are high, you don’t accumulate many shares. But when prices are low, you buy lots of shares, inherently creating a very cost-effective accumulation.
Tips for Success
Dollar cost averaging works best when used with funds rather than individual stocks, and with volatile investments so you can benefit from the price swings. If a given stock is on a permanent downward trend, there’s no guarantee the price will recover. But with a diversified fund, the manager can replace underperforming holdings, making DCA safer and more effective.
The key is to invest the same amount of money at the same interval – which is why DCA works best in your retirement plan at work, where contributions happen automatically with every paycheck. DCA, of course, cannot guarantee profits or the avoidance of loss.
Lump Sums Are Different
Dollar cost averaging is intended for the ongoing accumulation of assets as you earn income. If you receive a windfall – an inheritance, a legal settlement, a bonus – the rules change. Studies have shown that investors who invest a large sum all at once tend to make more money than those who spread it out over time. That’s because stock prices historically trend upward, and the sooner your money is invested, the sooner it benefits from that trend.