Dollar-cost Averaging (DCA) is an investment strategy that applies value investing principles to regular investments. It involves investing a fixed amount of money in common stocks at regular intervals, such as monthly or quarterly. This approach allows investors to buy more shares when prices are low and fewer shares when prices are high, potentially resulting in a satisfactory overall price for all holdings.
DCA provides time diversification, as the investor only needs to decide on two parameters: the fixed amount to invest each period and the frequency of investments. However, transaction costs such as brokerage fees and fund load fees may suggest a lower frequency of investments to minimize these expenses. By spreading out investments, DCA mitigates the risk of investing a large sum at an inopportune time.
The strategy is named for its potential to reduce the average cost of shares bought. Since the number of shares that can be purchased for a fixed amount varies inversely with their price, DCA leads to more shares being bought when prices are low and fewer when prices are high. This can lower the total average cost per share over time. Alternative strategies include purchasing a fixed number of shares each period or saving funds to invest when the market is low, known as market timing.
One major advantage of DCA is that it eliminates the need to decide the best time to invest funds daily, simplifying the investment process and promoting habitual or automated regular investing. DCA naturally occurs when investments are made from regular income, competing with lump-sum investing due to the “time in the market” effect on an upward-trending market.
DCA is most effective for volatile assets, as it allows investors to buy more shares when prices fall and fewer shares when prices rise, adhering to the “buy low, sell high” principle. Therefore, regular contributions to a 401(k) or IRA are better placed in stock funds. Periodic rebalancing can help maintain the desired asset allocation. The less volatile the investment, the less effective DCA is.
The website OfDollarsAndData.com found that even during the most challenging market periods, DCA into U.S. stocks has preserved purchasing power over time.
Similarly, a study by Schwab compared DCA with other investment strategies and concluded that investing immediately often yields better results. This is because perfect market timing is difficult to achieve, making regular and prompt investments a more effective approach.
In most cases, “Time in the Market Beats Timing the Market”. Therefore, consider DCA as regularly investing in the market as soon as you have funds available to invest. By investing regularly, you benefit from the compounding effect and mitigate the risk of making poor investment decisions based on short-term market fluctuations.