Dollar cost averaging is a well established, tested, and extremely reliable approach to accumulate wealth. An investor who wants to put a lump sum of money into the stock market or mutual funds is wise to invest the money over a period of time in equal installments in order to avoid the devastating effect of a drop in the stock or mutual fund’s share price immediately after investing a single, lump-sum investment.
What Is Dollar Cost Averaging?
Dollar cost average, or DCA, involves buying the same dollar amount of an investment at regular intervals over the course of a set period of time. In doing so, the investor will purchase more shares of an investment when the share price is low and subsequently purchase fewer shares of the investment when the price is higher.
Dollar cost averaging is buying a financial asset in a fixed timely manner regardless of share price. It is an implementation strategy to commit a fixed amount of money at regular intervals to an investment regardless of the price fluctuations in the market.
The Advantages Of Dollar Cost Averaging
The advantage of dollar cost averaging is that this method of purchasing shares of a stock or mutual fund helps smooth out the market’s ups and downs. By viewing market declines as buying opportunities, you can significantly enhance your long term return potential when the market rebounds.
The advantages become apparent when you sell a larger number of shares at a higher price than the average you purchased them for. Since you accrued more shares because your investment in them over time, your cost basis for your total investment will be lower as you buy more shares when the price is low and less when the price rises. Another advantage of dollar cost averaging is that it allows you to invest small amounts of money periodically which can be ideal for salaried professionals.
Dollar cost averaging is also psychological. It takes market timing out of the picture forcing investors to systematically purchase shares throughout market cycles. Most of Americans invest for retirement through employer-sponsored 401k retirement plans or Roth IRAs where we use dollar cost averaging without really realizing it. We invest a portion of our paycheck every pay period usually in a set amount regardless of where the market is at that moment.
The Disadvantages Of Dollar Cost Averaging
There are a few disadvantages of dollar cost averaging though that investors should be aware of when they consider investing. One factor that must be considered is a stock broker’s commission if the investor is investing in individual stocks. With each purchase, the broker’s commission can continue to eat away at an investor’s profits.
But, over time the commission will eventually become a smaller percentage as a proportion of the investment portfolio. There is also a disadvantage of having your funds automatically reinvested. You are not actively deciding how they should be invested, what allocations, which mutual funds, and other investing decisions. Thus, you may be missing better investment opportunities elsewhere if you are not carefully monitoring your investments.
Dollar cost averaging is great investment technique because it is the only way that many of the middle class can afford to invest. It forces investors to pay themselves first out of every paycheck.
Dollar cost averaging builds discipline with someone who may not be accustom to investing regularly. But, while dollar cost averaging has many benefits, investors should also be aware of the potential to be lulled into an investing trap as well.