What is dollar-cost averaging (DCA)?
Dollar-cost averaging is an investing method where an investor invests the same amount of money in a stock, mutual fund, or other types of security on a regular basis at fixed intervals. This might be every pay period or monthly or on some other timetable, and can be done with brokers like Ally Invest or E TRADE.
Using the DCA method of investing, when the price of the mutual fund or other security is low, the investor gets more shares for his money. When the price is high, his money purchases fewer shares. Using dollar-cost averaging eliminates the issue of trying to time the market and can be an excellent long-term strategy to accumulate positions in one or more securities.
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How to invest using dollar cost averaging
There are a number of ways to invest using dollar-cost averaging.
Stocks and ETFs
With the rise in popularity of fractional shares, dollar-cost averaging can easily be adapted to investing in shares of individual stocks and exchange-traded funds (ETFs). You can find out more about how to buy stocks and fractional shares here.
Dollar-cost averaging is the most common way to invest in a 401(k). Participants invest a set amount, usually a percentage of their compensation, each pay period. The investor then decides how much of their contributions will go into one or more of the 401(k) funds. And unless they change their contribution percentages or if their compensation amount changes, they will invest the same amount each pay period.
Many investment custodians and mutual fund companies also offer DCA options. An account holder might choose one or more securities within their account and make regular ongoing purchases of those securities. This might be done within a taxable investment account or perhaps into an IRA account.
Dividend reinvestment plans or DRIPs
DRIPs are generally established by publicly traded companies that pay a cash dividend. DRIPs allow shareholders to reinvest their dividend payments into additional shares of the company's stock. But since the amount of the dividend and other factors can change, not everyone considers DRIP a true DCA arrangement. However, it checks all of the boxes otherwise.
Using mutual funds for dollar cost averaging
Mutual funds are a natural fit for dollar-cost averaging. Investors normally buy shares of a mutual fund as a dollar amount instead of purchasing a certain number of shares.
Over time investing in mutual funds using a DCA strategy gives investors a way to invest with the potential for compounding. The ongoing investments in the mutual fund or funds continue to add up. As the mutual funds also appreciate in value over time, the money invested continues to compound in value. Also, most mutual funds throw off distributions in the form of dividends and/or capital gains. If you reinvest these distributions, they too will compound over time.
- If you use mutual funds for dollar-cost averaging, you should check that there are no transaction fees connected with the purchase of the fund. Such fee-free funds are less common than they once were, but they still exist.
- Keep in mind that many mutual funds charge a sales load. This is an upfront fee that reduces the amount actually invested by the amount of the load. For example, a fund with a 5% sales load means that only $0.95 of every $1 invested actually goes to work in your account.
- You should also be aware of mutual funds that have a transaction fee on the custodian platform. For example, if your account is with Fidelity Investments and you want to purchase a Vanguard mutual fund, there will likely be a transaction fee. This means that less than 100% of your money goes to work for you in the mutual fund of your choice.
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Dollar-cost averaging as a long-term strategy
Dollar-cost averaging is a solid long-term investment strategy for investors of all types.
While buying a security at or near its low point and then selling it after a significant gain is a great way to generate investing profits, very few investors can accurately time the stock market on a continual long-term basis.
Many experts talk about the benefits of time in the market versus timing the market as the key to long-term investing success. DCA dovetails well with the idea of long-term investing. Investing the same amount at a regular interval is inherently a long-term strategy. Using dollar-cost averaging requires a commitment to stick with this strategy. And that is a hallmark of a dedicated long-term investor.
But most of all, DCA can take the emotional aspect out of investing. Investors who are focused on timing the market and the day-to-day gyrations of their investments could make poor decisions based on their emotions. The ongoing periodic investments made via dollar cost averaging take the timing aspect out of investing. And this allows the investor to focus on accumulating assets over time.
Example of dollar-cost averaging
Here is an example of how dollar cost averaging might work. Let's say the investor invests $100 per month into a no-load, no transaction fee S&P 500 index mutual fund. Here's an example of what their fund balance might look like over a six-month period.
|MONTH||SHARE PRICE||AMOUNT INVESTED||SHARES PURCHASED||TOTAL SHARES OWNED||TOTAL VALUE||TOTAL COST BASIS|
As you can see from the example above, the amount invested each month remains constant. But the number of shares and the price at which these shares were purchased varied a bit each month. When the share price was higher, fewer shares were purchased than when the price was lower.
Rewards of dollar-cost averaging
While there are no guarantees in investing regardless of the methodology used, dollar cost averaging offers a number of potential rewards and can lead disciplined investors down the path of accumulating impressive sums of money over time.
Fidelity Investments does a periodic tally of the number of investors who have more than one million dollars in retirement accounts with Fidelity. And their recent count in February 2020 showed some 441,000 such millionaires. While everyone's situation is a bit different, investing in a 401(k) plan involves dollar-cost averaging. The ability to accumulate that kind of money takes time and persistence.
The main advantage of dollar-cost averaging is how easily the strategy can be used by investors of all experience levels and financial means. While it's not a get-rich-quick scheme, dollar-cost averaging can be an excellent way to build long-term wealth for those investors with the discipline to stick with it.
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