While many investors try to pick the bottom and the best entries for the highest possible returns, some prefer dollar-cost averaging, or DCA. This strategy significantly lowers investment risks by dividing the capital into a number of smaller buy entries.
Dollar-cost averaging explained
The investment method known as dollar-cost averaging (DCA) involves the investor making several purchases of an asset over time at various entry prices. Because the investor makes purchases over time rather than everything at once, a DCA method might lessen the volatility of an initial investment. Dollar-cost averaging can be accomplished with a 401(k) plan, where the investor selects a dollar amount or a percentage of their income to be routinely invested in their pre-selected investment selections, which are often mutual funds and ETFs.
A DCA approach works by making regular cash payments to purchase shares at various price points, which add up to generate an average price. However, this can be done individually by investors without needing a 401(k) plan or mutual funds through a broker. Instead, simply open an account at a good stockbroker and regularly invest in selected stocks or stock indices. As a result, you will significantly decrease market risk and increase your chance of profiting in the future.
How DCA works
An investor can use the straightforward dollar-cost averaging strategy to accumulate wealth in the long run and ignore all market volatility. Dollar-cost averaging is one of the finest investment methods for new investors wanting to enter markets. Many dividend reinvestment plans also permit investors to dollar-cost average their investments by making consistent purchases.
You can use companies to do this for you or a broker’s account to buy every week, month or quarter. Moreover, you can employ a strategy by buying after every market decline. For example, buy S&P 500 ETF after every 5% market fall. There are so many ways investors can do this, and still, the probability of winning using this strategy is high in all cases. Just avoid leverage if you want the minimal risk.
Example of DCA
Calculating the average or mean for a group of numbers works the same way as calculating dollar-cost averaging. When using DCA, the investor first adds the investment entry prices and divides the sum by the number of transactions. The formula for calculating dollar-cost averaging is following:
Average Cost = Total capital invested / number of units received
Let’s use a basic dollar-cost averaging calculation and example where an investor purchases $500 worth of shares of an ETF each month. When the investor checks their purchases after half a year, they discover that they purchased ETF units at various price points, including $50, $49, $48, $47, $52 and $51.
The investor would have received 10.00 units of the fund for their initial $500 investment ($500/$50 = 10.00). The investor would have gotten around 10.2, 10.4, 10.63, 9.61, and 9.8 units for the succeeding investments. From the six $500 investments, a total of roughly 60.64 units would have been received. By dividing the total amount spent by the number of units obtained, the average cost can be determined:
Cost on average: $3,000 / 60.64 = $49.47
In this case, if the investor had bought $3,000 worth of the ETF right away, they would have gotten 60 units for their money, with an average cost of $50 each unit. However, the investor dollar cost averaged a lower average cost of $49.47 and obtained 60.64 units. This example shows a little profit over just a few months’ time. This number could have been significantly larger if it had been six years instead of six months.
Benefits of DCA
While one appealing benefit of dollar cost averaging is the possible reduction in cost per unit, there are the following advantages to consider.
- Dollar-cost averaging develops the right habits. Although you know you should be investing frequently, it can be tempting to divert funds set aside for investments. You’re less likely to lose the money you invest, more likely to learn investing discipline, and more likely to stick to your plan if you set up regular investments.
- DCA makes it easier for investors to make decisions. No complicated formula. Just buy regularly and believe the economy will do better over time, increasing the stock market’s value. No need to time the market as well.
- It saves time by keeping things simple, as mentioned in the previous step.
- Dollar-cost averaging takes the emotion out of investing and prevents investors from gambling or speculating.
DCA is used mainly by investors who want to participate in markets but do not want to be invested emotionally and timely. It doesn’t matter if investors contribute monthly, quarterly or daily. Consistency and discipline are the crucial steps in this strategy, which is very simple and underrated by today’s people because, let’s be honest, no one wants to get rich slowly.