Dollar-cost averaging (DCA) is a method of investing that divides the entire amount into periodic purchases of a target asset to reduce the impact of volatility on the overall investment. The investments are performed regularly, regardless of the asset’s price. It is a tool that an investor can use to build up savings and wealth over time.
If prices are high, this technique allows you to allow only a limited number of shares. If prices drop, you can buy more shares using the set amount you invest for each duration. When the market recovers, you will gain from having purchased more shares at a lower price. With time, your average cost will almost probably be lower than the sum you’d paid if your market had been time-consuming.
Example of Dollar-Cost Averaging
Let’s imagine you wish to invest $1500 over three months. If you want to invest in security currently trading at $100 a share, you can buy five shares for $500 in a month. When you have another $500 to invest the next month, the price rises to $250 a share, and you can only buy two shares.
Following a market dip in the third month, the price has dropped to $50 per share, with 50 shares available for purchase. You’d invest $1500 over three months and end up with 85 claims. Even with price swings over the three months, the average cost per share for a $1500 investment with 85 shares is $17.6 ($1500÷85 = $17.6).
Now, if you sold your 85 shares for $1700 in month four at a $20 claim, you would make a $40 profit. If you sold your 17 shares for $3400 in month four at a $40 share price, you would make a $1900 profit.
- 85 shares (total shares) X $20 (share price) = $1700 (sell value) – $1500 (total investment) = $200 (profit)
- 85 shares (total shares) X $40 (share price) = $3400 (sell value) – $1500 (total investment) = $1900 (profit)
Benefits of Dollar-Cost Averaging
It is a highly strategic long-term investment. It helps to conserve funds, allowing for greater liquidity and flexibility in managing an investment portfolio. Your average cost per share reduces over time as you buy more shares at a low price. Average dollar costs are pretty attractive for beginner investors just starting up. It’s also a strategy to slowly but regularly generate wealth even when you begin with a bit of stake.
Drawbacks of Dollar-Cost Averaging
Dollar-cost averaging, like any other investment approach, has disadvantages. Some experts claim that using this technique can result in lesser returns than investing in a flat sum. The idea is that because stock markets tend to rise over time, leaving money out of the market can result in significant losses.
When you invest through a broker, you will usually have to pay brokerage fees for each transaction. As a result, if you invest in smaller increments rather than a single lump sum, you may wind up paying more fees.