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What is 'Dollar-Cost Averaging (DCA)'

Dollar-cost averaging (DCA) is an investment technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high.

BREAKING DOWN 'Dollar-Cost Averaging (DCA)'

The idea behind dollar-cost averaging is to cut down in any investment risks by investing the same dollar amount in the same investment over a period of time. This type of approach is used if you invest in a 401(k) plan. The DCA technique does not guarantee that an investor won't lose money on investments. Rather, it is meant to allow investment over time instead of investment as a lump sum.

How Dollar-Cost Averaging Works

Depending on an investor's investment objectives and risk profile, the monthly contributions can be invested in a mixed portfolio of mutual funds, exchange-traded funds (ETFs) or even individual stocks. Each month, the fixed amount buys shares at the then-current prices. As share prices decline, the fixed amount buys a higher number of shares. Conversely, when prices increase, the fixed amount buys fewer shares. The real value of dollar-cost averaging is that investors don’t need to worry about investing at the top of the market or trying to determine when to get in or out of the market.

Benefits and Disadvantages of DCA

There are a couple of benefits to using a dollar-cost average strategy when investing. First, if you're a newbie to the investment world, this is a good way to start since there's no real emotion tied to it and you're less likely to respond to a swing in price. Investing through DCA becomes a mechanical process. That means you can use the movement as a motivation or opportunity to buy more shares at a lower price.  

Secondly, because the market can be so unpredictable, it can give people who may be a little hesitant a good opportunity to start investing. By using the DCA strategy, the cautious investor doesn't have to look for the best entry point in order to invest in a particular security

But just like anything else in the investment world, there are some downsides to using the dollar-cost average strategy. Timing is a very key component to investing. While it may help you avoid some bad timing, using a DCA strategy also means you can miss out on some great opportunities. So you could end up losing on a chance when the market starts to trend upwards. 

DCA Example

For example, assume an investor invests $1,000 on the first of each month into Mutual Fund XYZ. Assume that over a period of five months, the share price of Mutual Fund XYZ on the beginning of each month was as follows:

• Month 1: $20

• Month 2: $16

• Month 3: $12

• Month 4: $17

• Month 5: $23

On the first of each month, by investing $1,000, the investor can buy a number of shares equal to $1,000 divided by the share price. In this example, the number of shares purchased each month is equal to:

• Month 1 shares = $1,000 / $20 = 50

• Month 2 shares = $1,000 / $16 = 62.5

• Month 3 shares = $1,000 / $12 = 83.33

• Month 4 shares = $1,000 / $17 = 58.82

• Month 5 shares = $1,000 / $23 = 43.48

Regardless of how many shares the $1,000 monthly investment purchased, the total number of shares the investor owns is 298.14, and the average price paid for each of those shares is $16.77. Considering the current price of the shares is $23, this means an original investment of $5,000 has turned into $6,857.11.

If the investor had invested all $5,000 on one of these days instead of spreading the investment across five months, the total profitability of the position would be higher or lower than $6,857.11 depending on the month chosen for the investment. However, no one can time the market. DCA is a safe strategy to ensure an overall favorable average price per share.

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