What is Dollar Cost Averaging?
Dollar cost averaging is a strategy of buying into an investment over time by purchasing small amounts periodically instead of making one large purchase.
This strategy allows investors to get the average price of the asset over time and reduces the risk of making a single large investment at an unfavorable price.
By spreading out the investment amount over multiple periods, such as investing $1 per day for 100 days with a $100 investment, investors can benefit from the fluctuation of prices. Dollar cost averaging is particularly suitable for long-term assets.
Many investment custodians and programs offer the option to dollar cost average. Dollar cost averaging can help mitigate the fear of market timing and the risk of missing out on investment opportunities.
Purchasing assets at lower prices over time provides the benefit of managing the basis and allows investors to take advantage of any price available. Dollar cost averaging can be used in various investment accounts, such as a 401(k), IRA, or accounts set up for children. It is a useful tool to invest without the need to time the market.
How Does Dollar Cost Averaging Work?
If you’re new to investing, think about dollar cost averaging as a way to reduce the risk of investing a large amount of money all at once. Instead of trying to time the market and make a single purchase of an investment, you can invest the same amount of money over a longer period in order to buy the same amount and invest the same amount over time.
This approach allows you to take advantage of the average prices over time and reduce the impact of short-term market changes. It also provides a sense of predictability and removes the pressure of trying to make perfect timing decisions. Dollar cost averaging can be particularly beneficial for long-term investments and can be used in various types of investment accounts, such as a 401(k) or IRA.
The chart above shows the price of Microsoft in 2023 on a Daily basis. (source: Finviz). The chart below shows the price of Microsoft on a Monthly basis. Buying periodically using Dollar Cost Averaging (DCA) could allow you to avoid large spikes and drops in the price by averaging the purchase price over a longer period of time.
What are the benefits of Dollar Cost Averaging?
1. Reduce the impact of market volatility:
By spreading out your investments over time, you are less affected by short-term market fluctuations. This can help mitigate the risk of buying at a high price during a market peak.
2. Average out the purchase price:
Dollar cost averaging allows you to buy shares or assets at different prices over time. This means that you will get an average purchase price, which can be beneficial if the price fluctuates significantly.
3. Disciplined investing approach:
Dollar cost averaging encourages regular and consistent investing. It helps you avoid making impulsive investment decisions based on short-term market movements.
4. Reducing the risk of mistiming the market: Trying to time the market by buying at the lowest point and selling at the highest point is extremely difficult. Dollar cost averaging eliminates the need to predict market movements, as you are consistently investing regardless of short-term price fluctuations.
5. Emotional control: Dollar cost averaging helps remove the emotional aspect of investing. Instead of making decisions based on fear or greed, you stick to a predetermined investment plan, which can lead to more rational decision-making.
6. Long-term wealth accumulation:
By consistently investing over time, you have the potential to accumulate wealth in the long run. Dollar cost averaging allows you to take advantage of the power of compounding returns.
It’s important to note that dollar cost averaging does not guarantee profits or protect against losses. It is simply a strategy that can help mitigate risks and provide a disciplined approach to investing.