When is the best time to invest? The answer to this century-old question is deceptively straightforward: when the price is low. However, market timing is extremely challenging, even for experienced investors. Additionally, investors can be affected by their emotions, greed, or fear, when making financial decisions. These are the reasons why many businessmans with a long-term vision use Dollar-Cost Averaging to help manage risks and eliminate emotional factors to gain profits.
What is Dollar-Cost Averaging?
Dollar-Cost Averaging is an investment strategy in which you invest the same amount of money in a target security on a regular basis, regardless of that asset’s price or market sentiments.
Due to timing risk, investing can be a significant challenge, even to advanced traders. Dollar-cost averaging can help investors solve this problem, deal with uncertain markets and emotional decision-making by putting a fixed amount of money into one asset at regular intervals.
How Dollar-Cost Averaging Works?
To get a better understanding of how dollar-cost averaging works, let’s see this example together. Say you have 500 bucks, and after having done a thorough technical analysis, you decided to invest in an index fund. However, you cannot calculate the exact timing, and you choose to opt in the dollar-cost averaging. Presume that you invest $100 per month for five months. As share prices vary at each interval, you receive a different amount of shares each time when you invest $100 as in this table below:
| Month | Investment (S) | Share price ($) | Units purchased | Shares total | Total value ($) |
| 1 | 100 | 5 | 20 | 20 | 100 |
| 2 | 100 | 3 | 33 | 53 | 159 |
| 3 | 100 | 2 | 50 | 103 | 206 |
| 4 | 100 | 5.5 | 18 | 121 | 665.5 |
| 5 | 100 | 6 | 17 | 138 | 828 |
| Total amount invested ($) | Average share price ($) | Total units purchased | Total value ($) | Profit/Loss ($) |
| 500 | 4.3 | 138 | 593.4 | 93.4 |
After making monthly investments of fixed amounts, your total investment after 5 months is $500. At the closing time, you have 138 shares with an investment value of $593.4. Therefore, you would have profited $93.4.
You can look deeper in this table to see what you actually had to pay. Though the average price per share at the end of the five months was $4.3, the actual price you paid for each share was significantly lower at $3.62 ($500/138 shares).
However, this is just an illustration. Dollar-cost averaging cannot always guarantee profits or protect investors from losing their money.
Benefits of Dollar-Cost Averaging
One of the most important benefits of dollar-cost averaging strategy is that it eliminates emotional factors out of investing. No matter what the market conditions or sentiments are, you just keep the discipline. If the market is on a downswing, DCA can help you buy more shares at a lower price, rather than being panic and selling off your holdings.
As demonstrated in the example above, this investment strategy can also help to average share price fluctuations and reduce the price you have to pay for each share.
Keep in mind that since this strategy is most suitable for long-term investments, it could help investors who do not have much money to build their positions in an asset over time. For instance, if you don’t have the whole $10,000 to invest at once, you can gradually add in and build up a position worth $10,000.
Finally, DCA keeps you open to opportunities. Even for professional investors or financial specialists, market timing is nearly impossible. DCA therefore ensures you’ll be at the door when opportunity knocks. Assume that the market suddenly plummets due to uncertain events such as a political election, and you stop investing. But just a few weeks later you may have to regret your decision when the market surges to record highs under the lead of the new government.
Disadvantage of Dollar-Cost Averaging
DCA, according to some experts, can gain you lower returns compared to a lump sum investment. The argument here is that stock markets tend to rise over time, and, therefore, leaving money out of the market can miss out on big gains. If you want to see the unicorn, you must take the risk.
Another point to consider is that you might have to pay more fees if you are investing with a broker. As you are investing at regular intervals, you must pay brokerage fees each time you make a transaction, and you could end up paying more fees than with one lump sum.
DCA Due Diligence
There is no panacea in investing. Every strategy has its advantages and drawbacks. To find the most suitable one, you must thoroughly comprehend the intrinsic features of a strategy. For DCA, we have outlined the alerts that we think the most useful that you should pay attention to:
Discipline makes success.
When the market is down, you may feel tempted to sell or stop investing as usual. Conversely, you feel you need to invest more in a rising market. However, all of these would nullify the nature of Dollar-Cost Averaging strategy.
Following this practice means that you must eliminate emotional factors and cannot fluctuate your position based on the current market sentiments. In the end, DCA is created for long-term investment horizons, so investors must have discipline to gain profits.
You must choose the right investment.
DCA cannot help you choose what asset to invest in. Dollar-cost averaging in a bad investment is still a bad investment. You must truly understand your asset whatever it is – shares, securities, or gold. Keep in mind that DCA is a tool, and its function is to support your business, not to do all the things for you.
Watch out for fees.
Investing on a regular basis means more transactions, which might incur more costs gnawing into your returns. This is particularly true for fixed transaction costs. Say a brokerage charges you $10 for every transaction you make. If you are a newbie and only invest $500 monthly, that could be 2% transaction fee, which is insanely high!
As a result, many investors favour low-cost, passively-managed index funds that charge a minimal percentage-based fee.
You might end up not like what you have dreamed.
The share price of an investment may increase over time, resulting in fewer new shares being acquired with each subsequent investment.
Dollar-Cost Averaging FAQs
Is Dollar-Cost Averaging a Good Idea?
Dollar-cost averaging (DCA) can be a beneficial strategy. By investing a fixed amount at regular intervals, you potentially lower your average purchase price over time. This approach ensures that you invest in the market regardless of whether prices are rising or falling. For example, you gain exposure to market dips when they occur, eliminating the need to attempt market timing. By consistently investing the same amount, you buy more shares when prices are low and fewer shares when prices are high.
Why Do Some Investors Use Dollar-Cost Averaging?
The primary advantage of dollar-cost averaging is that it mitigates the impact of investor psychology and market timing on a portfolio. By adhering to a DCA strategy, investors reduce the likelihood of making poor decisions driven by greed or fear, such as buying more when prices are high or selling in a panic when prices fall. Instead, dollar-cost averaging encourages a disciplined approach, focusing on regular contributions regardless of the target security’s price.
How Often Should You Invest With Dollar-Cost Averaging?
The answer is that it depends on your investment horizon, market outlook, and experience. If you anticipate a fluctuating market that will eventually rise, DCA might be a suitable strategy. However, it may not be ideal in a persistent bear market. For long-term investing, a practical approach is to align your investment intervals with your paycheck schedule, investing a portion of each paycheck regularly.
