Dollar-cost averaging (DCA) is a strategy in which a set amount of money is divided out into smaller sums that are then invested at set intervals. It does not matter what the asset’s price is at the time of the smaller investments. The goal of dollar-cost averaging is to try and avoid market volatility and the effects it can have on an investment. DCA can be especially helpful for a new investor by helping to minimize emotional investing.
How Does DCA Work?
Dollar-cost averaging is a basic investment strategy that uses a set amount of money to buy assets at regular intervals. Depending on the kind of investment you’re looking to make, DCA can be a great option.
Is DCA the Best Way to Invest?
Dollar-cost averaging can be a great strategy to use for investors that are looking to make investments with lower risk. It can be a great investment opportunity over time, especially in a bear market. This would mean that when you are investing at set intervals, the market is most likely at a low point, allowing you to obtain the best deals on your investments.
Is It Better to Dollar-Cost Average Weekly or Monthly?
There are different intervals in which you can invest when using DCA. While it is possible to make weekly or bi-weekly contributions, it makes more sense to use a monthly contribution interval. By investing monthly with the DCA method, you are more likely to yield a higher return.
Additionally, you are cutting down the risk of your investments with monthly intervals. Let’s say you were using the DCA method with monthly contributions. However, two weeks into your investment, you hear the share price is going to change. You would not be able to make any changes to your investment during this time. If you are not an experienced investor and are not able to determine if this will yield a positive or negative return, using the DCA method can be a great approach for you to keep you.
How Do You Calculate DCA?
To calculate your investment using the dollar-cost average method, you will need to keep track of the price you pay per share at each interval. You will also need to add up the amount of shares you are investing in.
Example of Dollar-Cost Average
For example, let’s say you are setting up DCA on a weekly basis for shares of company XYZ. Your plan is to invest $10,000 total over 4 months, at $2,500/month. You’ll calculate the number of shares purchased each month by dividing your monthly investment ($2,500) by the share price at the purchase date each month.
- Month 1: Share price 50. Number of shares purchased 50.
- Month 2: Share price 44. Number of shares purchased 56.
- Month 3: Share price 48. Number of shares purchased 52.
- Month 4: Share price 46. Number of shares purchased 54.
At this point, you would have 212 shares (50 + 56 + 52 + 54 = 212) of company XYZ with the average share price being $47/share. Now, if you had made a lump sum purchase at the beginning instead of a DCA approach, you would have had 200 shares of XYZ ($10,000 / 50 = 200). In this case, there is a 12 share difference at $47/share, worth $564. Since the market was declining, you ended up with additional shares. Had the market been increasing, you would have ended up with less shares purchased.
What Is the Benefit of Dollar-Cost Averaging?
There are several key benefits to investing using the dollar-cost averaging method. Using DCA can take the emotion out of investing. It can also help to avoid mistiming the market and can help to build wealth in the long term. Let’s review these below.
Using DCA to make your investment decisions can help eliminate the emotion that can sometimes affect investments. It can assist investors with focusing on the investments at hand and avoiding any short-term market performance predictions. While it is common for investors to make their decisions based on how they are feeling at the time, DCA can help take the emotion out of investments.
Another benefit to using the DCA strategy is that it allows investors to avoid bad-timing decisions. Investors tend to make many decisions based on how the market is doing at any given time and the market can be difficult to predict.
Choosing the DCA strategy, investors can avoid making rash decisions, such as selling off stocks when the market isn’t doing as well or buying lump sums at the wrong time. Instead, you would buy stocks when other investors are selling them, which can provide better long-term returns.
Using DCA can help build wealth over time. For new investors in particular, it can be a sure way to slowly build wealth. Typically, the average cost per share using the DCA method will most likely favor you had you made a lump sum purchase instead.
What Are the Disadvantages of DCA?
There are also key disadvantages to using dollar-cost averaging strategies when investing. These disadvantages are most prominent in an upward trending market. It also doesn’t remove all of the risk associated with investing.
Market Upward Trends
If the market begins to trend upward, there can be negative consequences to your investments with DCA. Because the stock prices are increasing in an upward trending market, and continuing to increase, this would end up preventing you from maximizing your gains had you made a lump sum purchase to begin with.
Doesn’t Take Out All Investment Risk
Deciding when to invest always carries some amount of risk. When using DCA, you may be able to minimize risk, but it is still there. A common theory with investing is the risk and return dynamic; higher return with higher risk and lower return with lower risk. DCA carries lower risk and therefore can come with lower returns than if you were to have made a lump sum investment.
Should I Use Lump Sum or Dollar-Cost Averaging?
The decision to use dollar-cost averaging instead of using a lump sum investment is ultimately up to you and the kind of investment you’re looking to make. Both types of investments come with benefits and disadvantages.
What Is Lump Sum?
A lump sum investment is exactly what it sounds like; using a lump sum of money and investing all of it at one point in time. If you were to use dollar-cost averaging, you would break your investments up into predetermined intervals over a specific period of time. Choosing a lump sum investment can carry more risk in the short term but can also offer higher returns.
Example of Lump Sum
If you remember our example of dollar-cost averaging from above, you will notice we compared it to making a lump sum investment. Let’s say you have $10,000 to invest. Instead of breaking up your investment over 4 months, you would take all of the $10,000 and purchase shares of company XYZ at $50/share. This means you would have purchased 200 shares of company XYZ.
As in the case above, the market was trending downward. Using the DCA method caused you to have 212 shares over a 4 month period of time instead of just 200 shares, had you made a lump sum purchase.
When to Use DCA vs Lump Sum
If you’re unsure which route to take when making your first investment, it may be beneficial to consider the DCA method instead of making a lump sum investment. There is lower risk involved, which means your emotions, such as fear and uncertainty, will not affect your investment decisions.
It may also be beneficial to use the DCA method if you have a longer period of time to spread your investment out. This can provide additional time for the market to correct itself to provide the most benefit.
Does Dollar-Cost Average Work for Cryptocurrency?
Knowing what we now know about dollar-cost averaging, we know that it is a viable option for investing in cryptocurrency. Ultimately, it comes down to how comfortable you are with the risk associated with investing in crypto.
We know that the crypto market can be quite volatile. For example, Bitcoin over the last five years has had numerous moments of increased price followed by a price decrease only a few days later. We’ve seen this exact thing happen to Dogecoin over the last 6 months, as well. However, knowing where cryptocurrency began and where it is at now can make it seem like a more appealing investment. We know that Ethereum has seen colossal gains since it first came to the market and it does not appear to be slowing down any time soon.
Using the DCA method for a volatile market may be the safest bet you can make when attempting to invest in cryptocurrency to protect against losses otherwise incurred with a lump sum investment.
Is DCA Right For You?
The bottom line comes down to how comfortable you are with investing. Are you new to investing and therefore, more fearful of what you are doing with your money? Or are you a more knowledgeable investor who is not afraid to take risks in the stock market? Understanding dollar-cost averaging can help you decide what to do with your money.
That being said, if you are still not sure of what investment option is right for you, you can always consult with a financial advisor. They will be able to guide you in understanding DCA versus lump sum and what option is right for you. A financial advisor can also help you manage your DCA investment, should that be the route you choose.