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Choosing which assets to buy is often as important as determining the right price that one should pay for it.
In this regard, people have attempted for decades to “time” the market by analyzing multiple macro and technical factors to identify potential market bottoms or late-cycle moves that are deemed to be followed by strong rallies.
This effort is particularly time-consuming and, in most cases, it has proven unrewarding as nobody can tell how the stock market, a specific financial instrument, or any other asset for that matter, will behave in the future exactly.
With that in mind, dollar-cost averaging (DCA) has emerged as a simple, yet powerful, strategy through which investors can take all the guessing out of the process of building a stock portfolio.
What Is Dollar-Cost Averaging?
Dollar-cost averaging, also known as DCA, is an investing strategy that consists of periodically disbursing the same amount of money to buy one or a group of assets when building an investment portfolio.
This strategy mostly applies to purchases of financial assets such as stocks, bonds, or cryptocurrencies as an investor can progressively build a diversified portfolio of multiple instruments that have been bought over time.
Pro Tip: Dollar-cost averaging is a strategy that can help you take emotions out of investing, think long term and avoid timing the market.
How Does Dollar-Cost Averaging Work?
A DCA strategy starts by determining how much money needs to be invested. Once that step is completed, the investor will establish a maximum period during which this amount will be disbursed along with a set of equal periodical intervals on which the purchases will be made.
For example, an investor who has $5,000 to invest can establish a maximum period of 25 weeks to fully allocate that amount. As a result, the person will invest a total of $200 every week — preferably on the same day.
As a result, the cost basis of each instrument held on the portfolio will be averaged and that will usually smooth out any sharp fluctuations in the price of the asset that may have occurred daily.
Nowadays, the introduction of fractional shares has facilitated the process of dollar-cost averaging for small portfolios as investors can buy a portion of a stock if needed to accomplish the goal of deploying the same exact amount into every asset that comprises the portfolio.
When to Use Dollar-Cost Averaging
Dollar-cost averaging (DCA) is one of the preferred strategies for building long-term investment portfolios regardless of the specific goal that the investor wants to achieve — i.e., retirement, wealth management, vacation planning. The following is a summary of how this strategy would work in different practical scenarios.
For 401(k)s and IRAs
Tax-deferred accounts are a great vehicle to build wealth and save for retirement as tax savings can be reinvested into the portfolio.
Dollar-cost averaging can be implemented in a 401(k) or an individual retirement account (IRA) by establishing weekly or monthly contributions that will be immediately allocated into the specific assets that comprise the portfolio.
In the case of 401(k)s, it is often easier to follow this approach as the money invested into the account will be immediately allocated upon reception.
For Self-Directed Accounts
With self-directed investment accounts, investors have to be more disciplined to implement DCA effectively as a strict schedule of asset purchases needs to be followed to achieve the goal of averaging the cost basis of every investment made.
Moreover, it is also important to make sure that purchases are being made according to the percentage that has to be allocated on each asset class or financial instrument that comprises the portfolio.
For example, a 60% stock and 40% bond portfolio would require that every periodical purchase made following the DCA scheme allocates 60% of the invested amount into stocks and 40% into bonds.
Exchange-traded funds (ETF) often facilitate the task of allocating the right percentage to each asset class and they bring an extra level of diversification to the portfolio as they are, by nature, broadly diversified vehicles.
Using Mutual Funds
Similar to ETFs, mutual funds are also diversified vehicles that invest in specific asset classes, market sectors, or follow a certain strategy.
Investors can use DCA with mutual funds in a similar way as they would with ETFs but transaction costs tend to be higher when using these vehicles, especially if they charge a load fee.
Nowadays, mutual funds have become less popular among retail investors due to their high carrying costs while they also increase the cost basis of a DCA strategy if a load fee is charged every time a purchase is made.
Dividend Reinvestment Plans (DRIPs)
A dividend reinvestment plan is a program through which investors can receive their dividends in the form of fractional shares. The purpose of DRIPs is to reduce the transaction costs involved in buying shares of the company again once the cash dividend has been received.
That said, DRIPs need to be deducted from the amount that would have been invested into the asset based on the composition of the portfolio as a fraction of that amount has already been allocated via the DRIP purchase.
Pro Tip: Keep in mind that dollar-cost averaging may not be suitable for all investments or market conditions. For instance, during market bubbles, your average cost basis will tend to be higher than it otherwise would have been.
Dollar-Cost Averaging as a Long-Term Strategy
For long-term investors, DCA is considered a way to put the portfolio on auto-pilot mode as all purchases are being made following an objective approach rather than trying to determine when the stocks or bonds that comprise the portfolio are trading at an attractive price.
The advantage of following a DCA scheme when investing for the long term is that it brings a systematic and disciplined approach to the process of building a portfolio while it relieves investors from the psychological burden of deciding if it is the right moment to invest or not.
Example of Dollar-Cost Averaging
To illustrate how dollar-cost averaging would work in practice, here’s a hypothetical example.
Joe is an engineer who earns a gross salary of $7,500 per month. Of that salary, a total of $1,000 will go every month to his 401(k) account while his employer will match 50% of that contribution.
Moreover, Joe has also decided to contribute a total of $500 every month to a separate individual retirement account (IRA) to build an even bigger retirement fund.
To simplify this example, we’ll focus on the $500 that Joe will be investing into his IRA as the money that goes into the 401(k) account is being managed by a pension fund.
All the contributions made to the 401(k) will naturally follow a DCA scheme as the money will be invested into the account periodically — usually every month or following the schedule that the company follows to make its contributions to the accounts.
On the other hand, if Joe’s salary is divided into two payments per month, this means that he can invest $250 every two weeks into the assets that comprise his portfolio.
For this example, let’s say that Joe’s portfolio is composed of the following:
- S&P 500 ETF — 50%
- Long-term US Treasury bond ETF — 30%
- Long-term US corporate bond ETF — 10%
- Grayscale Bitcoin Trust — 10%
Following a DCA strategy, the bi-monthly purchases that Joe would have to make would look like this:
- S&P 500 ETF — $125
- Long-term US Treasury bond ETF — $75
- Long-term US corporate bond ETF — $25
- Grayscale Bitcoin Trust — $25
Over the course of a year, Joe will be buying each of these financial assets on 24 different occasions. By following a DCA strategy, Joe won’t have to guess when to buy as purchases will be made according to this scheme.
Now let’s look at another example. Let’s say you want to invest a total of $3,000. You can either spread the investment over the course of six months or you can invest the entire amount from day one.
Scenerio 1: Dollar-Cost Averaging
In this scenario, you will be investing $500 per month for six months. When the market is up, your $500 will buy fewer shares, but when the market is down, your $500 will buy more shares. Over time, this strategy could lower your average cost per share compared to what you could pay if you were to to buy all shares at once at a higher price.
|Stock Price||Investment||Shares Purchased|
|Avg. Cost / Share: $10.16||Total Investment: $3,000||Total Shares Purchased: 305.74|
From this example, the average cost per share would have been $10.16 as the stock price declined from month 2 to month 6. The total amount of shares bought was 305.74.
Scenerio 2: Lump-Sum
In this scenario, you will be investing $3,000 from day one. From this example, the average cost per share would have been $12 for a total of 250 shares.
|Stock Price||Investment||Shares Purchased|
|Avg. Cost / Share: $12.00||Total Investment: $3,000||Total Shares Purchased: 250.00|
Benefits of Dollar-Cost Averaging (Pros)
- Facilitates the process of allocating funds for an investment portfolio.
- Reduces price volatility by spreading multiple purchases over multiple equally lengthy intervals.
- If the price of the instrument goes up during the holding period, gains tend to be higher when a DCA strategy is adopted.
- It relieves investors from the burden of determining if the price of the financial assets that comprise the portfolio is attractive or not at a given point in time.
Downsides of Dollar-Cost Averaging (Cons)
- Even if following a DCA strategy, portfolios will need to be rebalanced periodically to maintain the percentage of allocation set initially.
- DCA is not necessarily the most tax-optimal strategy.
- If the price of the portfolio assets goes down instead of going up during the holding period, a DCA scheme will not prevent the investor from experiencing a loss.
Dollar-cost averaging (DCA) is an easy to follow investment strategy that seeks to reduce the average cost of each financial instrument in an investment portfolio by spreading the amount to be invested into a series of periodical purchases made within a certain period at equally distant intervals.
Even though DCA does not prevent investors from experiencing a loss if the price of the financial assets goes down, it does reduce the cost basis of the investment. Over time, this scheme tends to increase the gains obtained from an investment as long as the price of the asset has gone up.
If you often struggle when trying to determine if it is a good time to enter the stock market or not, the DCA strategy can remove this psychological struggle through the implementation of a systematic approach.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.