What is dollar cost averaging?

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dollar cost averaging

Dollar-cost averaging helps investors earn higher returns on their investments with recurring contributions. People consistently contribute to their portfolios rather than invest all of their money in a single day. 

Dollar-cost averaging lowers your average cost basis, making it easier to break even and profit over time. Today, we’re discussing this strategy as we show you how you can use dollar-cost averaging to minimize your risks and expand your wins.

How does dollar cost averaging work

Investing into your portfolio each month helps you capitalize on the ups and downs of the market. Your existing funds grow during appreciation. When stock prices decline, you get more shares with the same money.

Dollar-cost average complements a long-term focus. Investors focus on what a company will look like in several years and accumulate new shares each month.

Why do investors use dollar cost averaging?

A dollar-cost averaging strategy reduces risks and slows an investor’s pace. Instead of rushing into every market opportunity and falling for FOMO, investors contribute a small sum to their portfolio each month.

If the market does not move in their favor, they still have funds available. Some investors hold onto cash when they believe a downturn is imminent. Dollar-cost averaging helps investors take advantage of dips and buy stocks on sale. 

Dollar-cost averaging also reduces the risk of counterproductive decisions. Lump-sum investors may panic if the market abruptly enters a correction. They may sell at a loss and become wary of future investments. Putting more money on the line causes investors to become fearful amid superb investing opportunities.

Example of dollar cost averaging

Dollar-cost averaging helps investors minimize risk and buy investments over time. This strategy reinforces the value of monthly contributions instead of lump-sum investments. 

With dollar-cost averaging, an investor can hold onto $1,200 and invest $100 per month instead of making a $1,200 lump sum investment. This example will reinforce this strategy’s concept. We will also highlight the advantages and disadvantages of dollar-cost averaging.

MonthShare PriceNumber of Shares Purchased
January$502
February$452.22
March$442.27
April$482.08
May $472.13
June$511.96
July $571.75
August$551.82
September$502
October$511.96
November$531.89
December$531.89

Benefits of dollar cost averaging

Dollar-cost averaging helps investors with less money to invest. Not everyone is sitting on a lump sum of cash. Some investors take a percentage of their paycheck and invest it into stocks each month. Continuously investing in your portfolio can build wealth over time.

Dollar-cost averaging also makes market timing less critical. In our example, the stock falls from $50 per share to $45 per share in a single month. Lump-sum investors would incur those losses without a method to lower the cost basis. Buying some shares at $50 and other shares at $45 reduces your cost basis, helping you return to break even sooner.

New investors can use dollar-cost averaging to take on less risk while learning about companies. Seeing a company in your portfolio may cause you to take that company more seriously. Investors may read the news on that company and watch macro trends before committing to another purchase.  

Downside of dollar cost averaging

The dollar-cost averaging strategy does have its flaws. The Financial Planning Association reveals many research analyses that favor lump-sum investing. Constantinides was the first economist to criticize this popular strategy, and simulations fueled his case. 

Rozeff ran a simulation in 1944 which revealed lump-sum investing strategies produced higher annualized returns than the DCA strategy. Another research analysis reached the same conclusion with a caveat. 

In 2000, Abeysekera and Rosenbloom conducted a study that looked at the topic of volatility. The lump-sum method often outperformed its predecessor, but the lump sum approach came with greater risks for volatile assets. 

Dollar-cost averaging is a safer investment approach with lower returns than the riskier lump-sum approach.

Dollar cost averaging vs lump sum approach

Dollar-cost averaging involves a gradual approach. Investors put the same amount of money into their portfolios each month, with other dollars sitting on the sidelines. The lump-sum practice focuses on infrequent but considerably sized investments. 

The dollar-cost averaging strategy turns $1,200 into 12 investments of $100 per month. The lump-sum plan takes that $1,200 and immediately deploys it into stocks.

The verdict for dollar cost averaging

Multiple studies gathered by the Financial Planning Association have revealed lump sum investments often outperform dollar-cost averaging. However, the DCA approach minimizes risks and offers a beginner-friendly investment approach. 

You can more easily learn from mistakes and recover from downturns. Dollar-cost averaging still holds a place in many investing strategies.

FAQ

Does dollar-cost averaging really work?

Dollar cost averaging helps you lower your risks and make consistent contributions to your portfolio. Some investors use this strategy to capitalize on dips.

How do you explain dollar-cost averaging?

Dollar cost averaging involves consistent contributions to your portfolio. Leaving money on the sidelines leaves you well prepared for a correction or crash.

What does dollar cost averaging mean?

Dollar cost averaging is the weekly or monthly contribution to a portfolio. Buying the same assets allows you to benefit from the ups and downs of your positions.

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